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European Economic Slump Affecting US Economy

Updated on September 25, 2014
ECB Headqurters Under Construction in Frankfurt Germany
ECB Headqurters Under Construction in Frankfurt Germany | Source

Sluggish Growth in Europe

Recent news indicates that European economic growth has greatly stagnated in recent times. In fact, Europe’s growth is so slow in 2014 that by comparison it makes the recent U.S. economic growth look out- rightly astronomical. In the last one year the overall economy straddling the Euro Zone has seen only 0.15% by way of growth, with the 2nd quarter GDP growing at an appalling 0%. This cannot be dismissed as a short-term trend, since the last time the zone saw a GDP growth on a long term basis of more than 1% was some 15 odd years back. It is intriguing to economists why Europe is experiencing such a sluggish performance in its market. Moreover, the impacts of such a trend are quite likely to quintessentially affect the growth of the U.S. economy in the short run.

Reasons for the Slow Growth

There are a collection of reasons that have been observed to account for the low growth of euro-zone economies. Some of them are rigid labor laws that have remained unchanged for eons, bad demographics, decentralized banking, decentralized government bureaucracy, decentralized political system, non-functional currency system and over-dependence on the welfare state net.

These are only some of the basic issues but they give a picture of what the obtaining situation there is like. One fact that clearly emerges is that many of the problems which are responsible for the sluggish growth in Europe are not repetitive in nature, but are systemic and of their own making. It is therefore Europe’s own efforts that will correct this situation. In doing so the countries in the zone will obviously have to consider what other countries in similar situations have done to change their circumstances and achieve higher levels of growth. One immediate neighbor to turn to is none other than Uncle Sam, who not too long ago faced an economic downturn at home.

Considering that economic progression in Europe has remained very low for such a long time, the main focal point for most political and economic leaders has been reflections of deflation pressures instead of the more proactive approach of building on inflationary pressures. Globally, economic trends exhibit low inflation and Europe is not an exception in this case. However, the European situation is seriously low in this sense thus making it to stand out.

New Monetary Measures by Mario Draghi

Against this economic downturn, Mario Draghi, European Central Bank (ECB) President, who is the European version of Americas own Janet Yellen; announced some corrective monetary actions beginning in October. These actions have been jokingly popularized in the press as WIT2 (second round of “Whatever It Takes.”) Though it is hardly a complete re-enactment of the American version referred to as quantitative easing (QE; nevertheless, the actions are strikingly similar to that of the U.S. version, where cash is “printed” and thrust into the banks so as to achieve the desired end of jump-starting demand for capital through several well thought out mechanisms.

It is easy to infer what will transpire in terms of changes by the ECB. First, the ECB will put up to $1.3 trillion in bonds in the market backed by real loans to the economy, which in turn will avail fresh capital. Many banks will, as a result, restructure their annual reports by selling some of their troublesome debts to the ECB in exchange for hard cash.

Secondly, the banking system will have an enhanced ability to make out more loans to members of the public. This may in the short term have no major effect on the requirement for capital. That is because loan demand will remain very lackluster; as the new excess capital generated will find its own way in the main financial markets.

Thirdly, the realization of the intended goals of the ECB will occur when a growth in the asset-backed market will finally begin to happen in Europe, as a transmission mechanism of mopping up excessive liquidity in the market. A partnership has already been created with Blackstone, a U.S. based securities asset manager and underwriter to this effect.

Fourthly, such a mechanism will be useful for the marginal and corporate debt markets as interest rates will continue to fall. As a result of this action there will be a weaker European currency in relation to the U.S. dollar. The outcome of a weaker currency will in turn be an increase in Europe’s exports, particularly in weaker economies.

Finally, if the program is successful, it will create an upsurge in economic activity while creating some level of limited inflation. Money printing inevitably leads to some extent of inflation. However, in this case inflation may very well be quite a positive occurrence because Europe has been on the verge of inflation for some time anyway. In any case the economic growth experienced will be positive despite the inflation. The end result will be one of success and not depression. Consequently, there is no need to be reluctant to take these inevitable steps so as to see an increase in growth for the highly depressed region.

The Eventual Benefits

As has previously been in the case of the U.S., the moment a central bank begins “printing” money as a radical economic corrective activity, the initial impact of the excess liquidity injection into the economy is to lift asset values considering that the liquidity must be absorbed somewhere. Where the actual economy doesn’t require or want the extra cash, its natural destination tends to be stocks and bonds in the capital market, thus raising prices there. This played itself out across the U.S. on three different occasions since 2009 as the Federal Reserve performed QE activities.

On the contrary, as happened in the U.S., questions persist about the benefits of QE activities in the long-term. It is not clear to this day what the ramifications of the Federal Bank’s QE will be eventually, however, the results will soon out. In any case, it is incredible that QE activities do have long term benefits, instead they are short-term adrenaline shots aimed at jump-starting a reluctant economy. It is precisely such a shot that the European economy sorely needs at the moment so that the long-term can sort itself out.

Summary of the Case

The bottom line is that Europe’s capital markets are expected to start a better performance than has been witnessed in recent times, as compared to U.S. stocks and bonds. It is true at the moment that many foreign capital markets are currently trading below their value compared to U.S. equities. There is an urgent need for a catalyst to unlock the undervaluation –Draghi and the ECB. If this is not done, then the European economy will inevitably affect other world economies, most of all that of the United States. It is therefore important that Draghi's actions are successful so that they result in a saving grace for the U.S. and all the rest. The situation remains dicey as the mechanisms are put in place to resolve the European situation. Nevertheless, the ECB President is inevitably keeping his fingers crossed to see which way things go. At the moment, what is clear is that something needs to be done urgently to arrest the slow growth out there in Europe.

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