The eye of the storm? (published in February of 2010 in the SB News Press)

In a time when, despite the economic woes we are experiencing, many seem supremely confident that the economy is recovering strongly, some have begun to question whether the recovery has legs.  These skeptics, of whom I am a reluctant member, point to the possibility of a “perfect storm” of potential economic, political and financial market problems that could derail the recovery, and push us into a deeper recession or depression.  In this week’s column, I will highlight some of these potential issues we could face that could put our economy at risk.

First, let’s look at one of the most recent issues that threatens our economy.  Greece has been in the news of late, with the revelation that they have been running a budget deficit that is 12 percent of their GDP (Gross Domestic Product).  They are a member of the E.U. (European Union), a group of 27 countries using the Euro currency.  One of the rules of membership is that no country in the group can run a budget deficit of more that 3 percent of GDP.  The government of Greece has been hiding their budget deficits, until they have become so large that the country can no longer operate. 
The question becomes: Will the stronger E.U. countries bail Greece out, or allow them to default on their sovereign debt?  This answer is not a simple one.  The vast majority of the money Greece owes was loaned to them by German and French banks.  Should Greece default on the approximately 85 billion Euros (about $115 million), these banks, and the entire banking systems of both countries and the E.U. overall, would likely be put in jeopardy, much like what happened in the U.S. when Lehman Brothers failed.  Luckily for us, the U.S. government acted quickly and had the financial strength to address the banking crisis and pull us back from the brink of complete financial collapse. 
Unfortunately, in Europe, although they do have the ECB (European Central Bank), which is somewhat similar to our Federal Reserve, the economies of the individual countries that make up the E.U. are only a fraction of the size of our economy.  For example, our GDP is about $13 trillion, while the UK’s is $2.65 trillion, Germany’s is $3.65 trillion, and France’s is $2.85 trillion.  All three of them combined are about $9 trillion U.S. dollars; about 70% of U.S. GDP.  More to the point, their economies are in far worse shape than ours (as bad as things are here), and unlike our situation, in which we are helping our own internal banking system and economy, they, if they chose to bail-out these countries, would be putting their internal economies and banking systems at extreme risk to help a foreign nation. 
More disturbing is the fact that Greece is not the only country in the E.U. that is in serious trouble.  Spain, Portugal, and Ireland are in similar shape, and Italy and others are not much better-off.  All together, southern European countries owe banks in Germany and France more than 600 billion Euros (about $816 million).  If Greece is allowed to default, there will likely be a domino effect, as each of these other countries in trouble defaults. 
The $800 million plus that is owed would be difficult for us to handle, but I think it is impossible for the E.U.  I do not think they can afford it, and I don’t think the stronger countries have the political will to deal with this problem either. 
This situation certainly has significant implications for us.  If the E.U. cannot deal with the debt issue they face, and these countries default, their banking system will collapse.  This, in turn, will devalue the Euro, which will make the dollar strengthen dramatically, at least against the Euro, but probably against other currencies as well, as capital flows to the U.S. as a safe haven.  A stronger dollar can be good and bad.  The bad part is that our goods will be more expensive for foreign consumers, so our companies that sell things abroad will make less money.  Commodity prices will likely fall, since most trade in dollars.  Our interest rates will likely be driven down as more money chases U.S. fixed income investments (this could be good if one owns bonds, or could cause inflation to increase eventually).  A stronger dollar is anti-inflationary, at least initially, which could be good, since the Fed would not need to raise interest rates as soon.
The biggest negative is that our banks do business with their banks, so if their banks fail or have serious difficulties, they could very well default on commitments to our banks.  We were reminded of the fact that our financial system is global when Bear Sterns, AIG, Lehman Brothers and the rest plunged the entire world financial system into chaos. 
I feel that the E.U. will come to us and ask for help, and it is possible that a package deal could be structured to bail-out these highly indebted countries.  If that crisis is averted, we will face a litany of other potentially serious problems. 
We are certainly going to face inflation at some point, which will require the Fed to raise interest rates.  The tricky part is finding a pace of rate increases that achieves the desired impact on inflation without killing the economy.  Even if the Fed is able to navigate this treacherous path, a rising interest rate environment will demand that investors make changes to portfolios.  Stocks can be dramatically negatively affected in a rising interest rate environment, as can bonds.  Bond investors especially will need to shorten maturities and take a much more active role in the management of their portfolios.  
Another thing that will inevitably rise will be taxes.  Despite Obama’s promises to only tax “the rich,” there are simply not enough “rich” people, defined as those making over $250,000 per year, to cover our massive budget deficits and national debt.  If interest rates rise, the cost of servicing our nearly $13 trillion national debt will skyrocket, and with ongoing budget deficits (we spend more than we bring in each year), we will continue to issue even more debt to pay the interest on the existing debt.  This new debt will have to be issued at higher and higher rates, meaning that the interest cost will spiral upwards. 
Everyone should be prepared for higher taxes, and not just on income.  We have a state budget deficit that could run as high as $20 billion or more, a county budget deficit estimated at $39 million, a city budget deficit estimated at $9 million for the 2011 fiscal year that will likely be substantially more than that number, and the Santa Barbara School District is facing at least $6 million in shortfalls, and likely more, once the State cuts more funding.  It is ugly, and everyone is going to have to suffer in the form of higher taxes and fees on virtually everything.
Finally, (and there are plenty more possible problems too numerous to include in one article), we face the very real possibility that Israel could attack Iran’s nuclear facilities.  Back in 1981, they flew a secret mission to destroy Iraq’s nuclear capabilities, which was successful.  There is no way Israel is going to allow any Arab country to acquire nuclear weapons that could be used against them.  If an attack were to occur, the energy markets would be interrupted, shipments from the Middle East would likely cease, at least for long enough to crash the financial markets and spike energy prices globally, all of which would put a severe strain on our already severely strained U.S. economy.
If you had two or more of these events occur simultaneously, I think it is easy to imagine what could happen.  I think the term perfect storm very accurately describes the potential for catastrophe.   So, are we in the eye of the storm?  It’s anyone’s guess.  But I think it is safe to say we are, at minimum, in the middle of hurricane season and we live on the Gulf Coast.
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