It appears Europe has just about run out of magic tricks to postpone the inevitable. As I mentioned in a previous blog about Greece, now all of Europe has reached the event horizon and entered the endgame.

Two choices remain. Let Greece, Italy and Spain default on their debt, or have the European Central Bank print massive quantities of Euros and buy all the debt issued by these countries for the foreseeable future. Which outcome will it be? It’s too early to tell. But the repercussions for American investors and business owners are becoming clear.

My colleague Gerald Klassen and I have been monitoring this situation all year and finally had some time this week to ponder the fallout from the results of the European endgame.

1. If the European Central Bank (ECB) turns on the printers and spews out a few trillion Euros, the value of the Euro will drop dramatically relative to other currencies. If the politicians choose the other alternative and let governments and/or banks default, the Euro will drop in value in the midst of a severe economic recession. Either decision results in a big decline in the Euro.
2. The drop in the Euro relative to the U.S. dollar would hurt U.S. exports and profits of U.S. corporations. A devalued Euro would make U.S. goods and services more expensive in Europe so Europeans would buy less. American importers may also be inclined to purchase more goods from Europe with the stronger U.S. dollar. Corporate profits would be hurt because S&P 500 companies get 14 percent of their revenue from Europe.¹ In addition to lost sales, profits earned in Euros would be worth fewer U.S. dollars so the foreign currency conversion would hurt profitability.
3. A decision to devalue the Euro via money printing will likely spur the Federal Reserve to undertake a large new program of quantitative easing (QE) to attempt to prevent damage to the U.S. economy.
4. The flight to safety into U.S. dollars will cause the dollar to spike in value and commodity prices to fall. Combine this trend with a slowing global economy, and commodities could fall dramatically. The benefit to U.S. consumers is that the threat of inflation would be reduced significantly. However, a large quantitative easing program by the Federal Reserve could ignite inflation fears as it did with QE1 and QE2. This could offset recessionary influences and provide support for commodity prices.
5. China and Japan will be big losers. Europe is China’s largest export market (bigger than the United States) so a recession in Europe would slow Chinese economic growth. A drop in the value of the Euro would cause significant losses in the foreign currency reserves of China and Japan.
6. Regardless of policy choice, the biggest European banks could become insolvent at worst or “zombie banks” short of equity capital at best. This would force them to reduce lending and possibly not renew loans when they mature. European banks are a major source for global trade finance. Emerging markets depend on European banks for $3.4 trillion in financing compared to $700 billion from U.S. banks .² Reduced credit could have a huge negative impact on emerging markets all over the world, in places like Africa, Central and Eastern Europe and Southeast Asia.
7. With a recession in Europe and much slower growth in China and other emerging markets, global investment money will flow into the United States as a “safe harbor.” This money will flow into our bond market and could cause interest rates on U.S. debt to go even lower than we see today. The ten-year treasury could fall to 1.5 percent or lower.
8. The impact on the United States depends largely on the response of the Federal Reserve. If the European Central Bank and Federal Reserve do not print more money, it is possible the U.S. economy could be dragged into a recession with deflation along with Europe. If both elect to address the economic crisis with more money printing, we will be entering an uncertain future as the grand monetary experiment gets pushed to new extremes.

¹ Miami Herald, “After Euro deal, investors brace for big moves,” Dec. 12, 2011

² David Rosenberg, “Breakfast with Dave,” Nov. 23, 2011

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