Kevin G. Hall - U.S. economy remains at risk from European financial mess

Kevin G. Hall | McClatchy Newspapers

November 10, 2011

http://www.mcclatchydc.com/2011/11/10/129972/us-economy-remains-at-risk-from.html

WASHINGTON — Stocks around the globe returned to positive territory Thursday, a day after European worries sparked steep losses. Europe's woes, however, remain a clear and present danger to the fragile U.S. economic recovery.

U.S. blue chips had fallen almost 400 points Wednesday on fears that soaring borrowing costs for Italy could push it into a crippling debt default. Those fears waned a bit Thursday as a new coalition government seemed to be taking form and there was more clarity from Italian lawmakers over promised economic reforms.

Borrowing costs remain elevated for Italy, a nation with a $2.6 trillion deficit and about $300 billion in borrowing needs over the next year or so. On Wednesday, Italy was forced to pay investors a 7.6 percent rate of return on its 10-year bonds, well above the 7 percent threshold at which other European nations were forced to seek rescue packages.

Investors eased up on Italy on Thursday, and the rate of return on the benchmark 10-year bond fell to 6.873 percent, slightly below the danger zone.

With Italy calming, U.S. stocks recovered some lost ground. The Dow Jones industrial average closed up 112.92 points to 11,893.86, while the S&P 500 rose by 10.60 points to 1,239.70. The NASDAQ gained 3.50 points to end at 2,625.15.

This week's financial volatility underscored how problems in Greece and now Italy not only can contaminate neighboring countries but also pose risks around the globe. Whether it's surging oil prices, slower sales by U.S. corporations operating in Europe or reduced demand for U.S. farm exports there, the downturn in Europe already is sending shock waves to our shores.

Here are some answers to questions about the European economic fallout:

Q: Wasn't this a crisis about Greece?

A: Partly, and in Greece there were important developments Thursday as Lucas Papademos became the prime minister. A former vice president of the European Central Bank, he's an economist with a strong sense of the austerity measures his country must carry out. He's a technocrat, not a career politician, and he could be just what the country needs: an impartial doctor to give Greece the bitter medicine it requires. The Greek Parliament soon must approve a bill to implement the austerity plan that was agreed to in late October in exchange for a roughly $11 billion rescue payment from the European Union.

Q: How does that affect Italy?

A: Italy is expected to follow suit and soon form a new national unity coalition. Right now it appears likely to be headed by a technocrat without political baggage: economist Mario Monti. This came after Wednesday's sharp rise in Italy's borrowing costs, which was akin to a buyers' strike against Italian bonds to protest the lack of needed reforms. Financial markets feared that Prime Minister Silvio Berlusconi would keep ruling from behind the scenes, and they wanted a clean break.

"Has there ever been a margin call on the debt of the government of a major industrial country? I don't think so, but there was one yesterday on the Italian government's debt," investment guru Ed Yardeni said Thursday in a research note. Margin calls usually apply to banks and other financial firms that are borrowing on credit, and they require the posting of additional money when an asset loses value. Once there's a margin call, it's hard to attract new money from creditors. Margin calls helped bring down U.S. investment bank MF Global last week.

Fears of Italian default eased Thursday as a national unity government is expected to cut spending, sell state real estate assets, revamp labor laws to boost competitiveness and make other reforms.

Q: How bad off is Italy?

A: Many analysts think Italy is better off than many of its struggling neighbors because it hasn't had a real estate bubble or severely weakened lending standards. And Europe's third-biggest economy is a diversified and resilient one.

"They can still stumble out of the current crisis. We continue to argue that Italy is better placed," Raj Badiani, a London-based economist with forecaster IHS Global Insight, wrote Thursday in a note to investors.

Because of its size, however, Italy is considered too big to bail out. If its leaders make bad decisions and lending costs stay high, its only option could be a default, which would have global consequences.

Badiani puts default odds at 15-20 percent, "which would lead to a meltdown of the Italian banking system, given its large exposure to Italian general government bonds, and bring about a deep and extended credit crunch."

Such a default would bring great harm to neighboring France, warned Bernard Baumohl, the chief economist for forecaster The Economic Outlook Group.

"The fate of Italy and France are in many ways conjoined. French lenders are the largest foreign holders of Italian public and private debt," Baumohl warned in a research note, suggesting that a domino effect could be triggered, reaching U.S. shores.

He added, "I suspect the calm public demeanor of U.S. Treasury and Federal Reserve officials belies a terrifying fear they have that the global economy is about to be dragged into another financial meltdown."

Q: How vulnerable is the United States to problems from Europe?

A: Federal Reserve Chairman Ben Bernanke was asked this very question Thursday when he met with solders at Fort Bliss in El Paso, Texas.

"There's definitely a significant risk there. The world financial markets are highly interconnected, so if there were to be a substantial increase in financial stress in Europe ... that would create a freezing up of credit, a withdrawal of sources of funding, decline in stock prices. All those negative things would happen, not just in Europe but around the world," Bernanke answered. "It is not something that we would be insulated from. ... I don't think we'd be able to escape the consequences of the blowup, as it were."

Q: Oil prices have spiked again; is this because of Europe?

A: Partly. Oil no longer is traded only between users and producers, and it's become a store of value, similar to gold, as a financial refuge. Contracts for future delivery of crude oil leapt $2.04, or 2.1 percent, to settle at $97.78 per barrel Thursday on the New York Mercantile Exchange. This jump, up sharply from under $80 a barrel in early October, was partly a reflection of bullish sentiment as Italy fears eased, and it also partly reflects growing concern about Iran.

The International Atomic Energy Agency reported Tuesday that there's growing evidence of Iran trying to create a nuclear bomb, raising concerns that Israel soon might launch a pre-emptive strike against Iran. That could provoke Iran to disrupt global oil markets, so oil traders again are building a fear premium into the price of oil. An oil-price spike earlier this year set back the U.S. recovery sharply; it's the last thing the U.S. economy needs right now.