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European Versus American Debt - Outside View by Asad Dossani

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European Versus American Debt
Nov 15, 2010

The currency market tends to shift back and forth between different ideas regularly. Before the summer it was all about Eurozone debt worries, and this pushed the euro down against other currencies. Since then it has been all about the Federal Reserve easing policies and the corresponding dollar weakness.

The euro has suffered some falls in the last couple of weeks as news is beginning to resurface about the debt problems in the Eurozone. Bond yields in peripheral countries are rising, raising fears of more bailouts or debt defaults to come. Most analysts are expecting that Ireland and Portugal will follow Greece and end up needed a bailout or having to restructure their debt.

The US also has high levels of debt. The government is running a massive budget deficit, and individual states within the US are also facing large scale debt problems. Yet no one talks about the US defaulting on its debt, or needing to restructure or get bailed out. US bond yields are very low – meaning that investors have full confidence that they will repay their debts. Why is it that peripheral Eurozone countries are seeing rising bond yields and investors effectively pricing in some form of restructuring?

The answer to this question lies in the way that each is dealing with the debt problems. The US answer to this problem is to print more money. The Federal Reserve’s policy of quantitative easing is to print money to buy government bonds. Effectively this means printing money to fund its deficits. In Europe, nothing of this sort is occurring. There is no monetary easing by the ECB, and peripheral country debt problems have to be dealt with by cutting their deficits or risk facing default, restructuring, or needing a bailout.

Which approach is the correct one? Monetary easing is clearly easier to implement, and it tends to have good effects in the short term. US bond yields are much lower than peripheral Eurozone bond yields and this will allow them not to be overburdened by their debts. Contrast this to Europe, where countries will have to face significant falls in government spending, rises in taxes, and less economic activity to deal with the debt.

In the long term, it is much less clear. Too much monetary easing can lead to asset price bubbles, and eventually crashes. Arguably, the entire financial crisis of 2007-09 was a result of too much liquidity caused by the Federal Reserve having very loose monetary policies. On the European side, there is a bigger risk that they could spiral into recession again it would be a while before they came out of it.

The correct approach is some sort of combination of the two. In the short term, monetary easing is helpful because it prevents bond yields from going too high, and prevents deflation from occurring. This should also be accompanied with strong efforts to reduce deficits and bring down the level of debt. The US has certainly failed on this last point, and the result could easily be another stock market bubble that is just waiting to crash.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

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