Why President Obama Can Stop Worrying About Europe
Can President Obama’s increasingly confident reelection drive come undone because of the economic turmoil in Europe? That is a question that many in the White House are said to be worrying about.
The fears have some foundation based on recent experience. The relatively strong US economic recovery in early 2010 — 3.9 percent growth in the first quarter and 3.8 percent in the second — was at least partly cut short by the accelerating negative impact on growth and confidence from, first, the unfolding Greek crisis, and then euro area-wide debt emergency. Indeed, Europe likely shares a bit of the blame for the populist success of the Tea Party in the 2010 Congressional mid-term elections, spurred by a slowing US economy in late 2010 as the initial “green shoots” seemed to dry up. Small wonder that the President’s team appears petrified over the potential impact of a further deterioration in the euro area debt crisis on the tentative US recovery — and by extension the President’s reelection chances in November.
Fortunately for President Obama, however, he can now scratch the euro area off the list of potential pre-election risks.
First, the recent decisive deployment of the European Central Bank (ECB) balance sheet — expanded 45 percent since August 2011 — to support the euro area economy through purchases of government bonds and the unlimited three-year liquidity for the European banking system have calmed regional financial markets. Consequently, the looming risk of a “European Lehman moment,” in which a large European bank would suddenly collapse and cause widespread systemic turmoil — and possibly have required a federal bailout of another US bank — has been dispelled for the foreseeable future. No large European bank is going to go bust for at least as long as it enjoys the benefits of the ECB’s long-term liquidity injections. This fact takes us well beyond November 2012. As a result, neither the Fed nor the Treasury needs to worry about an intervention that would be exceedingly unpopular with voters.
Second, it is clear that euro area growth in 2012 will be very slow, although the region looks likely to narrowly escape recession for the year as a whole. However, the ECB’s actions have prevented a large credit crunch in Europe and hence effectively acted to prevent a repeat of the terrible decline in the euro area economy in 2009. The euro area will not slump, and slow growth for the year is now priced into the markets, which means diminished chances of further negative shocks to the global and US economic outlook. Consequently, the euro area stagnation in 2012 is unlikely to materially affect the US economy and hence the election campaign.
Third, the imminent Greek bond swap will effectively take the private sector out of Greece and eliminate another potential source of contagion from Europe to the global financial system. Certainly, there is plenty of scope for continuing volatility in Greece. But from now on, the instability will mostly stem from an intra-euro area fight between the tax payers in Greece and those of the rest of the currency union, without huge immediate market impact.
The International Monetary Fund (IMF), whose largest shareholder is the US government, has become the senior official creditor for Europe, but it will not in any case face losses. Whether the Greek bond swap takes place as a voluntary or coercive restructuring, or triggers the use of credit default swaps for investors, it will largely be a non-event with no noteworthy negative effects on financial markets. The system is protected by the limited scope of outstanding sovereign Greek credit default swaps (just over $3 billion) and the well-funded status of euro area banks accessing the long-term refinancing operations (LTRO) of the ECB.
Even the worst case scenario for Greece, in which it fails to implement its new IMF program and faces a possible loss of IMF support later this year, is unlikely to have a material impact on the US economy ahead of the election. Moreover, another worst-case possibility — the small chance that Greece might decide to quit the euro area — looks unlikely to happen or metastasize until around November at the earliest. This suggests that any potential for a Greek exit and the market contagion risk of such a move will not occur until after the US election. Greece, for all its serious problems, therefore looks quite unlikely to harm President Obama.
Fourth, while some uncertainty surrounds the two other IMF programs in Portugal and Ireland, both countries have been adhering to their IMF programs and look likely to continue to do so. This will mean that both — in line with repeated euro area statements — will get more funding should they not regain market access upon finishing their current IMF programs. As is the case of post-bond swap Greece, this is therefore an issue between taxpayers in different euro area countries with next to no spillover potential to the United States or global economy.
Fifth, the ECB’s decisive action has bought time for euro area leaders to solve the underlying structural problems facing the common currency. These problems include the urgent need to overhaul labor markets to restore job opportunities, press on with the recapitalization of the euro area banking system, and continue the institutional integration of the euro area. Without such progress, employment will not rise, euro area banks will remain zombies, and the euro area will still be a half-built house. In such a terrible scenario for Europe, the opportunity from the ECB’s recent action to calm markets will have been wasted by euro area policymakers — a failed gambit by central bank leaders in Frankfurt. There are therefore plenty of risks still lingering in the euro area and there is plenty for leaders to do. However, all of these structural issues are of longer-term concern and will not be resolved ahead of November and will therefore not pose a material downside for the Obama reelection campaign.
Sixth, leaving aside Greece, where domestic policy may take a dramatic negative turn in 2012, the political calendar in Europe until November does not look particularly risky. The only major election looming is in France, where the concerns in the markets surrounding the possible election of Socialist president Francois Hollande are overblown. If elected, Hollande would not be able to stop the Fiscal Treaty in Europe, although he might be able to demand an additional “growth protocol” attached to it. Nor will his election cause the Franco-German relationship to shatter. France is too weak to dictate policy to German today, and the two countries are so closely intertwined that an awkward first meeting between Hollande and Merkel will overcome any lingering mutual anxieties.
Concerning the “European firewall” — the establishment of financing mechanisms to stabilize markets and stop contagion — the politics are slowly falling into line, too. Last week the euro area leaders confirmed their commitment to re-assess the adequacy of the overall ceiling of the European Financial Stability Facility (EFSF) and its offshoot, the European Stability Mechanism (ESM), by the end of the month. In addition, they agreed to accelerate, through national parliamentary procedures, the payment of the paid-in capital for the ESM, starting with the payment of two tranches in 2012. A revised timeframe for the payment of the remaining tranches will be agreed upon by the end of the month. These commitments show that the leaders want to see the result of the Greek bond swap and let domestic politics cool off a little after recent votes over the second Greek bailout. But their statements mean that there will be more European money coming into the ESM and faster before the IMF/World Bank spring meetings on April 20-22. In other words, Europe and the IMF look likely to have the money for a bigger firewall well before any new shenanigans in Greece and well ahead of the crucial final stretch of the US election.
Then there is the issue of the Irish referendum. If the Irish surprise everyone and reject the new Fiscal Treaty, they would not be able to block it outright. Unlike a regular EU Treaty, the Fiscal Treaty takes only 12 countries to ratify it for it to come into force. A rejection by Ireland would cut the Irish off from future funding from the ESM. But Ireland would still be bound by all of the fiscal oversight carried out by the EU Commission (i.e., with rules identical to the Fiscal Treaty). Without access to the ESM, Ireland would surely find it politically impossible to go directly to the IMF for help, as too many shareholders in the fund would resist lending more money to a European country without (junior) euro area participation. Ireland is a member of the IMF, so will not be turned away. But the IMF Board will never lend it any money without the ESM. In the end, the Irish can be trusted to do the smart thing.
Events — October Surprises — can always pop up and suddenly change the course of elections. But if an unforeseen event upends President Obama’s reelection quest, the origin is not likely to have been Europe.
Copyright © 2012 PIIE.