A Look At The Eurozone In 2012

By Stephen D. Simpson, CFA | December 28, 2011 AAA
A Look At The Eurozone In 2012

With the European sovereign debt crisis well into its third year and all but certain to continue in 2012, investors may well be weary of the entire subject. Unfortunately, the tendrils of this crisis reach far and wide, influencing not only the banking system and economy of Europe, but of the larger world as well. Given that Greece is hardly in the clear, fears still surround the situation in Italy, and Spain and Portugal are still in a precarious state, investors may well be asking if Europe's problems will ever end. (For related reading, see The Contrarian Play In Europe.)

TUTORIAL: The Banking System

The State of Things Today
After multiple rounds of extensive and coordinated intervention and outright manipulation on the part of Western central banks, it seems that government bankers have at least called the markets here near the end of 2011. Dollar and euro liquidity seems to be readily available (though not always on great terms), and worries of failed bond sales seem to be fading.

It's another matter entirely, though, to say that things are safe or stable. Although Ireland's bailout appears to have worked, Ireland was a smaller mess to clean up. Greece has needed several interventions and there are still abject risks that Greek citizens will tire of the austerity measures and effectively tear up the agreements, to say nothing of the fact that worse-than-expected economic performance in Southern Europe would put those plans under severe stress.

Likewise, there are still rampant worries about Italy, Spain and Portugal. All of the nations have troublesome debt and underlying economies that are too reliant upon their governments and internal consumption, as opposed to competitive export-driven industries.

Making matters worse, worries about the capital position of major European banks have slowed lending and financing activity, further applying the brakes to trade and economic growth. Should Greece, Italy or Spain default, or should further economic stresses force another downward revision of the estimated value of debt holdings, many banks would need more capital, which may not even be available at this point, and some would likely fail, further paralyzing the market.

As if that weren't enough, there are still open questions as to whether the eurozone can even survive. Germany already seems fed up with this mess and may increasingly see little value in compromising its own interests to preserve its neighbors.

More Trouble on the Way
Bad as things are, there are reasons to believe they may get even worse. Greece and Italy will be hard-pressed to reform their economic and social systems fast enough to suit the market. Debt is too high as a percentage of GDP and investors are increasingly demanding higher rates to roll that debt over, making interest payments a higher proportion of national budgets and further limiting these nations' budget flexibility.

Keep in mind, too, that austerity programs actually make some of these numbers worse before they get better. If there's any validity to the theories that governments can stimulate economies by spending, then the opposite has to hold true and significant cutbacks in government spending and transfer payments will reduce economic growth, making the various statistics on budget deficits and debt burdens even worse. That too assumes that the citizenry will even go along with the plans to their conclusion; if sentiment builds that debt defaults won't hurt the "regular people," it will be even harder for governments in stressed economies to stick to these austerity programs.

As this happens, several countries need to reform and liberalize. Both Italy and Greece are hampered by rules, laws and regulations that make it more difficult and more expensive to create or expand businesses. In many cases as well, businesses have "grown up" with a sort of government-supplied buffer against competition and unrestrained capitalism will be quite a change in how business is done.

It is also worth asking if there is room for everyone to fix their problems at once. Spain, for instance, definitely needs to find a new growth engine, as much of its growth in recent years was fueled by extensive foreign investment and spending within Spain. Unfortunately, not all of these countries will be able to fix themselves by shrinking the role of government and encouraging export-oriented industries; they simply do not have cost structures that are competitive with China, Southeast Asia or Eastern Europe and there is only so much demand out there, as many other developed nations are looking to fix their economic troubles with a greater emphasis on exports. (To learn more on how trade affects economies, read Macroeconomics: International Trade.)

What Could Go Right?
If the above is a brief rundown on what can yet go wrong, what about the other side of the coin? What could go right for Europe in the coming year?

Emerging markets could be one of the better helping hands. While China has already declined to help out directly, and it has the resources to buy European debt in large amounts if it so chooses, they along with other countries, like India and Brazil, continue to import large amounts of machinery and technology products. This, though, is a good news and bad news situation; much of this money flows into the already-stronger countries of Europe like Germany, France and the U.K. and helps the struggling countries only insofar as it keeps their benefactors afloat.

A growth recovery in the U.S. would also be a help. The U.S. is a large market for European exports, U.S. tourists have long enjoyed European destinations, and a healthier U.S. economy would free up more capital to buy up undervalued European assets.

Last, and by no means least, is the possibility that European countries will adopt a fairly radical re-think of their policies, and their views on the government's proper role in the economy. Many of Europe's struggling countries would benefit from greater economic liberalization and less involvement from the government in the business of business, such as laws concerning wages, hours and employment guarantees, for instance. At the same time, there is room to cut regulations, eliminate layers of bureaucracy and often byzantine rules, and reduce benefits, all of which could make it easier, more appealing and more necessary to seek work in the private sector.

Some may also see a possible benefit in one or more countries simply defaulting, leaving the eurozone and starting over anew. This would definitely be a traumatic event and the waves radiating out from it would likely lead to several very bad days in our own markets. That said, many countries have defaulted and eventually repaired themselves, and there is an argument that sometimes amputation is better than ongoing painful treatments that simply delay the inevitable and make things worse.

The Bottom Line
For those already sick of the European sovereign debt crisis situation, 2012 is likely to offer little respite. Although many of the participants now seem much more realistic about the scale of the problem and the size of the response that is needed, problems that are a decade or more in the making seldom resolve quickly and conveniently. Eventually there will be solutions and an end to this trouble, but that is likely to take some time. (For related reading, see 5 Economic Reports That Affect The Euro.)

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