08.08.11

Downgrade Hurts Europe More

In normal times, you might expect Europe to benefit from a U.S. downgrade, as investors shift their funds into the world’s other AAA countries. But as Stefan Theil writes, Europe is in even worse shape than the U.S.

It was only with massive intervention by the European Central Bank in the bond markets that market mayhem was stopped on Monday morning, at least for now, though European stocks were firmly in the red. The move followed frantic phone calls Sunday evening among European leaders, caught on their vacations when news of the S&P downgrade hit.

Shock waves from Friday’s historic U.S. downgrade threaten to accelerate Europe’s own debt crisis—which has been festering and spreading since Greece became insolvent last year—and infect bigger countries like Italy, Spain, and ultimately France.

German Chancellor Angela Merkel, on a hiking vacation in the Italian Alps, conferred several times over the weekend with French President Nicolas Sarkozy, who is on holiday on the French Riviera. An emergency conference call between finance ministers and the European Central Bank late Sunday night helped push the ECB into action.

The calls started on Friday, when Merkel and Sarkozy put intense pressure on Italy’s scandal-plagued prime minister, Silvio Berlusconi. In an emergency news conference following the phone calls that night, Berlusconi announced that Italy will accelerate spending cuts to eliminate its government deficit by 2013. The country will also add a balanced-budget amendment to its Constitution, becoming the world's second major economy to outlaw federal deficits, after Germany passed a similar amendment in 2009.

In normal times, you might expect Europe to benefit from a U.S. downgrade, as investors shift their funds into the world’s other AAA countries, most of which are in Europe, including Germany and France. None of this has happened. This morning, the dollar was slightly higher against the euro (you’d expect a big drop if investors were moving money out of the U.S.), and 10-year U.S. Treasury bills actually gained in value during early European trading.

Why? If you think America is in a mess, the debt crisis in Europe is even worse. Even though Europe is in better fiscal shape overall, its problems are even more intractable than the budget stalemates in the U.S. Congress. The worst that can happen in the U.S. is that Congress can’t decide on debt reduction, leaving the Fed to inflate the debt away.

The worst that can happen in the U.S. is that Congress can’t decide on debt reduction. Overall, Europe’s problems are even more intractable than the budget stalemates in the U.S. Congress.

In Europe, however, sick countries like Italy and Spain have no control over their own currency, leading some to speculate on a messy breakup of the euro zone. Richer countries like Germany and France have already bailed out Greece, Ireland, and Portugal. But Italy and Spain, which together would be the world’s fourth-largest economy after Japan, are much too big to bail out. The costs of another big bailout would likely bring down France, considered by many analysts to be next in line for losing its AAA rating.

Worse, Europe is still in the middle of a full-fledged banking crisis, with French and German banks alone holding $1.2 trillion in public and private debt from insolvent Greece, Ireland, and Portugal, plus wobbly Italy and Spain, according to the latest numbers from the Bank of International Settlements. Many European banks are alive only through a continued massive bailout by the European Central Bank, which has pumped more than $120 billion into the banks of tiny Greece and another $200 billion into those of just-as-tiny Ireland.

No wonder Europe suffered worse during America’s messy budget debate. During last week's crash, Europe’s Eurofirst stock index lost 10 percent, versus a 7 percent drop for the S&P. Until Europe gets its twin debt and banking crises under control, the shock from Friday's downgrade could hit it worse than America itself.