Economic Forecasts

U.S. Warily Watching Europe's Economic Austerity

Even a weak dollar won't protect American exporters from sharing Europe's pain.

Europe's tough-love austerity is for real. Debt-plagued governments will stick with it, despite widespread strikes and protests in France, a budget standoff in Portugal and earlier demonstrations in Greece and elsewhere. Britain's stiff upper lip will provide moral support to others that need to cut spending and hike taxes.

But tight budgets will crimp growth, dampening spending by consumers and businesses. That will stunt the recovery in some European Union states, push others back into recession and deepen the plight of those EU members that have yet to see the light of day.

Europeans are "betting the economy is solid enough that they won't face a second dip in the near future," says Juan M. Licari, a London-based economist with Moody's Analytics. “Maybe they're overestimating the capability of the private sector to take on public workers that will be laid off in the next year or two."

The European austerity moves will hurt on this side of the pond, too. U.S. exporters will feel the loss the most. They count on Europe for 20% of overseas sales, and even the weak dollar, which makes goods cheaper in Europe, can't overcome the fears of unemployment and bankruptcy that weigh down demand for goods. American manufacturers of IT, biotechnology, automobile and aerospace parts, chemicals, plastics, medical equipment, green technology and security gear will take the hardest hit.

For multinational corporations, it will be more of a zero-sum game. Europe hosts 52% of U.S. foreign direct investment, while 64% of European FDI resides in the U.S. A stronger euro helps offset weaker sales by affiliates of U.S. firms in Europe but compounds the damage for EU firms with U.S. affiliates.

U.S. policymakers are watching Europe closely for lessons to learn as well as mistakes to avoid. Deficit hawks will call for action now, warning that the longer the U.S. waits, the worse the budget pain will ultimately be. Plus they'll claim an election mandate. But politicians are also wary of moving too quickly and hurting growth. Democrats aim to delay spending cuts, particularly to social services, while Republicans oppose tax hikes.

With the U.S. economy still fragile, the question of timing is huge. If Washington or governments in Europe move too quickly to balance their budgets and growth founders, revenues could fall more than spending, raising the deficit. That’s why even with EU austerity moves, there's no guarantee that weak members can avoid default. The $612-billion EU rescue plan provides a backstop only until May 2013.

The U.S. deficit relative to gross domestic product is in the same ballpark as much of Europe. U.S. red ink for fiscal year 2010 came to 8.9% of GDP, down from 10% in 2009. Greece, after enacting its draconian budget cuts to stave off default, slashed its deficit from 13.6% of GDP in 2009 to 8.9% in 2010, well above its 8.1% target. Ireland managed to narrow its gap from 14.3% with 11.9%. For Spain it was 9.3%, down from 11.2%, and for Portugal, 7.3%, compared with 9.4%. The biggest EU economies backloaded their cuts to 2011. For them, the real pain is yet to come. The United Kingdom's 2010 deficit comes to 9.9%; France's, to 7.7%; Italy's, to 5%; and Germany's, to a modest 4%.

Europe's austerity will also provide a unique test for monetary policy. Expect the Bank of England to follow the Federal Reserve, which is set to buy hundreds of billions of dollars' worth of Treasuries to provide more stimulus. Not so for the European Central Bank, which is opposed to providing such a boost. The pound and the euro have largely moved in sync against the dollar up to now, but the divergence in policy will weaken the former and keep the latter strong.

"We've been waiting for a clean experiment of how much difference currencies make for getting out of this crisis, and we're about to have one," says Barry Eichengreen, a professor of economics at the University of California at Berkeley. Tight budgets in both the U.K. and the major euro zone economies will act as a control factor.

Slower economic growth worldwide will dampen trade, limiting the boost a weak pound might grant British exports. By comparison, Eichengreen says, "it will be quite magical if continental Europe is able to continue growing as it has been for the last six months without support from fiscal policy and without support from monetary policy." This may provide another lesson from which the euro zone can learn, but it could also bolster the arguments of those in countries at risk of default that devaluation is the way to restore competitiveness. The only way for a country to do that would be to withdraw from the euro zone. That would threaten the currency union's survival, as one such defection would surely trigger others.

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