Deleveraging with Pain

As we observe the still-unresolved Greek debt crisis, it is important to realize that the deleveraging we are undergoing in the Euro Zone, the U.K. and the U.S. is a painful process. The New York Times carried an Associated Press story, "I.M.F. Slashes Growth Outlook for U.S. and Europe": "The fund said it expected the American economy to grow just 1.5 percent this year and 1.8 percent in 2012. That's down from its June forecast of 2.5 percent in 2011 and 2.7 percent next year. The International Monetary Fund also lowered its outlook for the 17 European Union countries that use the euro. It predicted 1.6 percent growth this year and 1.1 percent next year, down from its June projections of 2 percent and 1.7 percent respectively... Over all, the International Monetary Fund predicted global growth of 4 percent for both years. Stronger growth in China, India, Brazil and other developing countries should offset weaker output in the United States and Europe... American and European policy makers need to act more decisively to cut budget deficits, the report said, and European officials need to ensure that the region's banks have enough capital to withstand the debt crisis... Olivier Blanchard, the organization's chief economist said, 'President Obama's proposal to cut taxes and spend more on infrastructure should provide much-needed short-term stimulus. But that initiative needs to be paired with a longer-term plan to reduce the deficit. The timing of the budget cuts is key. Budget cuts cannot be too fast or it will kill growth. It cannot be too slow or it will kill credibility.' " (AP, September 20, 2011)

This painful and slow-moving process in Greece and the European Union has been going on much longer than the debate in the U.S. over raising the debt ceiling. Landon Thomas Jr. wrote in yesterday's New York Times, "But some economists believe default may be inevitable - and that it may actually be better for Greece and, despite a short-term shock to the system, perhaps eventually for Europe as well. They are beginning to wonder whether the consequences of a default or a more radical debt restructuring, dire as that may be, would be no worse for Greece than the miserable path it is currently on... What would the impact of a default by Greece be on Italy? In a new sign of trouble for the country (Italy), Standard & Poor's on Monday cut Italy's credit rating by one notch to A, citing its weakening economy and limited political response." ("Greece Nears the Precipice, Raising Fear," NYT, September 19, 2011) On Tuesday it was reported in the Wall Street Journal, "The European Central Bank stepped in to the market to buy Italian government bonds Tuesday after a sovereign-rating downgrade by Standard & Poor's Corp. raised new concerns about Italy's solvency amid a slowing economy." (WSJ, September 20, 2011)

The impact of an outright default on the European banks is unknown, but it is being suggested, "Bailing out the banks will be crucial if Greece either defaults or imposes a hard restructuring, whereby banks would be forced to take a larger loss on their holdings compared with the fairly benign 21 percent losses that they are now being asked to accept as part of the second, 109 billion euro bailout package set for Greece in June." (NYT, September 19, 2011) If Greece does default, will they remain within the European Union with its common currency, the euro, or would they exit the euro zone and return to their former currency the drachma and then devalue their currency versus the rest of Europe?

It is clear that this deleveraging process is very painful on all levels. Finding the right balance between stimulating growth and embracing austerity is playing out on a daily basis. Unfortunately, no one group or political party seems to have found the right balance and the frustration level grows both within the financial community and the individuals who cannot find productive work in this high unemployment environment. Deleveraging is a surgical process that must be done with care to insure that the western economies do not repeat Japan's lost decade.