Not So Far Away: Why Europe Matters
Global economic news in 2011 was dominated by the financial crisis in Europe. However, it’s fair to wonder whether a few European countries that default on their debts would have any bearing on the Central Massachusetts economy. After all, Argentina, a country with an economy much larger than Greece’s, defaulted on its public debts 10 years ago. The ripple effects from that were barely noticed outside South America. So, are the fates of Greece, Ireland, Portugal and the other peripheral countries really such a big deal for us?
Yes. It’s a really big deal.
Although most news stories are about government budget deficits and austerity programs, this is a banking crisis at its root. But it’s the ripple effect that matters. If Greece were to default today, it would cause many highly leveraged banks to default. This would cause banks that loaned money to those banks to default. Nobody knows whether the financial system will simply break down as it did when Lehman Brothers defaulted in 2008. If it does, Europe will plunge immediately into recession and almost certainly drag the U.S. back into recession as well.
Local companies with direct ties to Europe will be most heavily impacted. Several of our largest employers are subsidiaries of European companies, including Saint-Gobain, AstraZeneca and Citizens Bank. If a European recession causes American exports to drop significantly and the dollar to rise against the Euro and other currencies, then the risk will not be limited to companies with direct exposure to Europe. For example, my employer, Clark University, would be impacted if a sharp rise in the dollar makes it more expensive for foreign students to enroll here.
There could also be significant costs to investors. In 2011, the MSCI EAFE index, a benchmark for international stocks, declined about 10 percent. Another credit crisis would cause a drop of at least that much in global stock markets, including here in the U.S.
My prediction is that Greece will be thrown out of the Eurozone in 2012, but that the remaining countries will remain in the union. European voters remember that Greece should not have been admitted to the currency union in the first place. A condition for admission was a budget deficit of less than 3 percent of gross domestic product. Greece’s true deficit was never less than 3 percent, but its government used very creative accounting methods get around that. There’s little appetite among German and French voters to continue bailouts now that it’s clear that Greece’s admission was essentially fraudulent.
Greece will be let go as soon as regulators are convinced that the banking system can withstand the strain. The concern is that regulators might reach that conclusion too soon. Remember that the U.S. Federal Reserve declined to bail out Lehman Brothers because it thought our financial system could withstand the strain. They were wrong.
Richard Spurgin is associate professor of finance at Clark University’s Graduate School of Management in Worcester.
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