Policies of Scale: Efficient Global Policy

For 2013, Worry About Europe

If one were to ask the average American where they thought the US was investing most of its money abroad, I am willing to bet they would probably choose somewhere in the Asian continent, likely China or India. After all, our trade is in deficit ostensibly thanks to this region, and most global commerce benchmarks are built around trade. Therefore, they would be quite surprised when you told them that, no, American investment is overwhelmingly in Europe. When considering the risks to the US economy in 2013, the economic ties we have with Europe make the worry of a prolonged recession there, or worse, downright frightening.

To give a brief over view of the transatlantic economy, it was valued at $5 trillion in 2012, and is the largest and wealthiest market in the world, representing over half of world GDP in terms of value and 41% in terms of purchasing power. Ties are quite deep in foreign direct investment (FDI), portfolio investment, banking claims, trade and affiliate sales in goods and services, research and development, patent cooperation, technology flows, and sales of knowledge-intensive services, which can be a force multiplier for growth. Of total US investment abroad, Europe accounts for roughly 55% while, for comparison, China receives only 1.3%. Between 1990 and 2009, US firms put more capital into Ireland and Spain than China. One would not necessarily think this based on the emphasis often placed on Asia.

According to downside analysis in the OECD’s Economic Outlook Number 92 (December 2012), a euro-shock based on sovereign and banking stress intensifying significantly relative to the baseline projection, and corresponding confidence and financial deterioration, would reduce world GDP growth in 2013 by    0.7% in 2013 and a 1.4% in 2014. The Euro area’s numbers would be 2.2% and America’s 0.3% and -0.5%:

Source: OECD Economic Outlook Number 92.

Even with the US fiscal cliff still threatening to wreak havoc, the euro area, according to OECD Secretary General Angel Gurrial, is “where the greatest threats to the world economy remain.”

To begin an analysis of this statement, one may be tempted to begin their analysis with trade. However, economist Joseph Quinlan argues in his book, “The Last Economic Superpower,” that a better indicator for how immersed countries are in other economies is foreign direct investment and sales of foreign affiliates. Companies compete more through these avenues than through arm’s length trade, he says. He sites as part of this argument The Economist who called FDI “globalization in its purest form” and attributes it with representing far more than just capital: “it is a uniquely potent bundle of capital, contacts, and managerial and technological knowledge” (page 148).  Global FDI in 2009 was $18 trillion. Global Foreign affiliate sales reached nearly $30 trillion the same year. Compare this combined total of $48 trillion to roughly $16 trillion in global exports and, says Quinlan, it is investment that binds nations, especially our nations, not trade.

I am inclined to agree. Combined, the US and Europe accounted for 25.4% of global exports and 32% of global imports in 2010. However, we combined for 57.8% of global inward stock of FDI and 72.8% of outward FDI, much of it built up in each other’s economies. The European market is the largest for US services abroad, representing nearly 54% of total US foreign sales. Most foreigners working for US companies outside the US are Europeans, and most foreigners working for European companies outside Europe are American. About 38% of the 11.3 million people employed by US majority-owned affiliates in 2010 lived in Europe. By these measures, Europe is easily the most important geographic market for America. In 2008, $2.7 trillion of foreign affiliate sales were to Europe; only $1 trillion were to Asia (page 150).

Looking at inflows, America accounted for 16% of global totals over the last decade (and 22% since the early 1990s). Over this period, the ratio of dollar inflows to the US and China is three-to-one. Europe accounted for roughly three-forths of total foreign capital investment in the US between 1990 and 2009 (pages 150-151). From 2003 to 2007, the US was the destination for over 70% of Europe’s outward FDI (page 155). European FDI inflows were $120 billion in 2011, declining from $173 billion in 2010. Yet the US remains the most significant market for European multinational earnings. Daniel Hamilton and Joseph Quinlan expect European affiliates to earn a record high $120 billion profit from US operations in 2011 when reporting is complete. This income resonates because affiliate sales, rather than trade, are the primary means by which European companies deliver products and services to the US consumer; 2010’s sales were more than triple US imports from Europe.

US affiliate output in Europe totaled $625 billion in 2010 and expanded in 2011 (compared to $148 billion from China in 2009). Profits from 2011 reached a record high of an estimated $213 billion, although profit accumulation slowed over the forth quarter.

Hopefully I’ve begun convincing you that US growth from engaging the global economy ties us very much to the fate of Europe. When globalization started booming in the early 1990s, this turned out to be a very good thing for us, and the Europeans as did quite well ourselves. But Europe is back in recession, and actually has been for over a year according to The Centre for Economic Policy Research, a network of over 800 economics from across Europe. The conclusion they reached in September was that “the peak of economic activity [in the euro zone] coincides with that of GDP. In other words, the euro area has been in recession since 2011Q3.” Further, “At its 2011Q3 peak, GDP in the euro area was still roughly 2% below its previous 2008Q1 peak….key macroeconomic aggregates have also been decreasing markedly since the third quarter of 2011, such as euro-area consumption, investment and employment.” This portents dark days for the US, and the Europeans have stumbled over themselves making sure the clouds do not dissipate for either of us.

Given Europe’s toxic combination of pro-cyclical austerity and tight monetary policy, along with tighter banking rules under Basel III, credit has become scarce and the resulting equilibrium is far from optimum. Without a stimulus “shock”, the whole system has been plagued by disincentives to grow economically. Some countries are even doubling down on this strategy. France, for example, has austerity measures representing 2% of GDP scheduled to take effect in 2013. Spain, plagued by high borrowing costs, has been resistant to a bail-out for fear that the stronger EMU economies like Germany, The Netherlands, and Finland, may impose difficult terms – likely greater austerity.

Yet these countries, once thought to be solid anchors against further euro zone drift, are showing signs of succumbing themselves. The Dutch economy shrunk by 1.1% in the third quarter of 2012. The Finnish economy has shrunk by 1% over the last year. Austria shrunk 0.1% in the third quarter. German growth slowed progressively over the first three quarters from 0.5% to 0.3% to 0.2% while its unemployment rate rose for the eighth straight month in November. Euro zone unemployment rose to a historic high of 11.7% in October. Meanwhile, falling core inflation and wage moderation is limiting purchasing power of the euro, providing another source of drag on the recovery.

In the same December OECD economic outlook referenced above, GDP is expected to decline by 0.1% across the Eurozone in 2013; in May’s forecast, growth was expected to be a positive 0.9%. Unemployment is supposed to rise from 11.1% in 2012 to 11.9% in 2013. Unfortunately, these projections are actually more optimistic than some private forecasts, though the OECD is predicting a weaker GDP performance than either the European Commission (0.1%) or the IMF (0.2%).

It will be difficult for the US to escape further contagion. US exposure to European banking risk is substantial. While US loans and claims on Greece and Portugal, and even on Spain, are limited, our exposure to banks in France, Germany, and the UK, who are in turn heavily invested in Greece, Portugal, and Spain, are substantial:

Source: Hamilton and Quinlan, 2012.

Triggered by deleveraging of European banks in the US, it was through these links that the European financial crisis began spreading to the US. Through this interdependence of transatlantic capital markets and thus through trade, corporate earnings, and sales, we will not be spared Europe’s troubles. As the US has returned to positive growth, financial contagion from Europe continues to be a drag on US progress. On trade alone, robust expansion of US exports to Europe of 13.1% in the first eleven months of 2011 was masking the fact that by November of 2011 exports were expanding by just 4.8% on a year-over-year basis. Exports to France, Germany, and Ireland actually declined by 8.8%, 7%, and 8.5%, respectfully, from the year prior.

Weak European demand will put a drag on US earnings and job growth. The combination of rising unemployment and austerity means a likely prolonged period of crisis in Europe. Further, this dynamic is likely to give cause to the forces of protectionism in Europe, further limiting US exports and creating European and global market distortions.

The US and the other IMF board countries have left Europe to its own devices because they believe Europe has the wealth to sort out their crisis, which has persisted because of the internal mechanisms of the EMU (and as I have argued before, the poor conception of the union itself). While the IMF and its members have rightfully stayed out of the financing and bailing out business in Europe, if things continue to go poorly or take a turn for the worst in 2013, the US may not be able to afford maintaining this kind of political and diplomatic distance; Europe may or may not have the financial capital, but thus far it has not had the intellectual capital.

As Ezra Klein recently pointed out in a Bloomberg piece, I think correctly, our own country faces an “austerity crisis” where the US has “too much austerity, imposed too quickly.” Europe is experiencing its own crisis where its austerity has been too much, imposed too quickly, and maintained for too long. As we try to pull ourselves out of our crisis, it is time for us to more strongly urge Europe to grab the rope themselves.

A note on sources.

References to page numbers refer to:

Quinlan, Joseph. “The Last Economic Superpower: The Retreat of Globalization, the End of American Dominance, and What We Can Do About It.” McGraw-Hill, 2010.

Unless otherwise specified, economic data is from:

Hamilton, Daniel S. and Quinlan, Joseph P. “The Transatlantic Economy, 2012.” Center for Transatlantic Relations at the Johns Hopkins University Paul H. Nitze School of Advanced International Studies. 2012.

Leave a Response