A Sliding Euro and Debt Crises Could Push Europe Back Into Recession


It's no wonder investors are scrutinizing the sliding euro. Concerns about Greece's debt load and speculation that more crises are brewing in larger economies like Spain's are rattling global markets. Some of the world's largest hedge funds are even placing massive bets that the currency will sink to trade at an even level with the U.S. dollar. Those gambles are being compared to George Soros's legendary bet against the British pound almost two decades ago.

But while bailouts for some debt-laden European countries are manageable, and the speculation that the euro may not survive could be excessive, its drop in value nevertheless points to a big danger for the fragile global recovery, one that will persist even after those debt issues are resolved. Europe, the world's largest importer, may be on the verge of sliding back into a recession. And as governments scramble to rein in spending in order to combat the debt crises, the dampening in demand is likely to compound the problem.

Even as the rest of the world shows signs of recovering -- fourth-quarter U.S. GDP expansion was revised up to 5.9% on Friday, and China's growth rate is north of 10% again -- Europe remains near stalled. It reported only a 0.1% gain over that period. Austerity measures like cutting stimulus spending and unemployment benefits, and raising taxes to tackle the debt-issues will only add to the likelihood of a double-dip recession.

That will leave the European Central Bank (ECB) in no position to raise interest rates, even as the rest of the world shows some signs of tightening credit. Analysts at Bank of America Merrill Lynch, for example, had anticipated in January that the ECB would start raising rates by the second quarter, but now they're not forecasting rising rates until December. The euro, which has slid to a value of $1.36 to the dollar from above $1.50 in December, will remain limp in such an environment even if concerns about its survival fade.

Painful but Not Insurmountable

Some on Wall Street, however, may have chalked up too much of the slide to concerns about the euro's survival. "There is no doubt that on a technical level, the euro is massively oversold," Gluskin-Sheff economist David Rosenberg wrote in a research note this week. "But on a more fundamental basis, the question over its sustainability is not likely to subside any time soon."

But while the problems facing the euro are serious and will require painful adjustments, they're hardly insurmountable. In the near term, authorities like the ECB or even the International Monetary Fund can help to arrange financing and support bond issuance. Over the long haul, what will be needed, as Soros recently outlined, is better monitoring of the finances of individual European governments and a more explicit arrangement for providing assistance when it becomes necessary.

Tough as those measures may be to enact, the pain would be minor compared to the chaos that would be unleashed if the euro were to be disbanded or if key economies pulled out of the unified currency. Still, the relative stagnation of Europe's economy will likely prevent the sort of sharp rebound in the euro that often follows an equally sharp technical sell-off.

Rebalancing and Depreciation Can Help

A weak euro -- which would make exports more competitive -- may be exactly what the region's ailing economy needs. French President Nicolas Sarkozy has been an outspoken critic of Chinese monetary policy, which keeps the yuan undervalued and tips the balance in favor of Chinese exporters. A weakening of the euro relative to the dollar -- to which the yuan is pegged -- reduces that Chinese advantage somewhat.

A gradual rebalancing and euro depreciation, in other words, may ultimately be in Europe's interest. But investors would be wise to follow the high-wire act closely. Any misstep -- reining in government budgets too sharply, for example -- could plunge the region back into a recession. And that would have massive implications for markets worldwide.