Commentary - 10/1/2010

Today’s economic data was mixed with good data here in the United States and more uncertainty in Europe. We offer some insight into both market drivers in this weeks blog entry. ---  Consumer spending increased again in August, second quarter GDP was revised upwards yesterday, and incomes are up! Consumers are also saving more, which is both good and bad. It’s good because savings makes funds available for investment. It’s bad because it cuts into consumption, and the economy depends on consumer spending. Indeed, consumer spending makes up about 70% of the economy, so any increase has a strong effect on overall economic activity. Households are deleveraging by increasing savings and by refinancing their homes at incredibly low mortgage rates. As consumers pay down their debts, they are also more likely to spend more in the future. Rising consumer spending over the last two months bodes well for the economy. Coupled with a lower trade deficit, it should give us a solid GDP reading for the third quarter.

Going forward it is critical that businesses invest in themselves. Companies flush with cash are reluctant to spend it on new equipment and more employees. They apparently lack sufficient confidence in the recovery. Until companies with cash invest more and until banks with reserves make more loans, economic growth will remain slow. Instilling more confidence in the recovery is the dilemma of the moment.

What’s going on in the European Union? Ireland may have to bail out its banks to the tune of one third of its total annual economic activity. Amazingly, Ireland may be able to do so without seeking help from its fellow Euro Zone nations. Spain and Portugal may have similar problems, leading some to worry about the dissolution of the Euro itself. From a purely economic standpoint, the Euro Zone may be a suboptimal currency union. While currency unions do remove barriers to trade, they also take away each country’s monetary independence. Unlike the U.S., Ireland can’t lower its rates to zero because more prosperous members of the union don’t want to. The PIIGS (Portugal, Ireland, Italy, Greece and Spain) could help themselves with a flexible monetary policy that would allow them to create easy money and inflation, making their debts worth less. However, Germany and France will not allow that to happen because their goals are quite different. So why should the Euro continue with these vastly different goals? The Euro will likely survive for a few reasons. Europeans like to look unified, and lower trade barriers are good for everyone. It’s likely too that Germany will bailout its weaker members. Germany is an export-led economy that benefits from weakness in the Euro created by the PIIGS. While it may have to foot a large and politically ugly bill, it benefits more from having its goods sell cheaper around the globe.