Most of us probably know more about Greek mythology or about Sparta from watching the movie 300 than we know about modern-day Greece. We might order moussaka when we are at a Greek restaurant, but we really don’t think about Greece the rest of the time.
In fact, the global village is now so closely linked that some economists believe the European debt crisis, emanating from countries like Greece, Spain, Portugal, and Ireland, will cause a slowdown in the U.S. economy. Europe is a big market for many American companies and as Europe’s economy slows and the Euro drops in value, U.S. corporate profits could suffer.
Calling it a European debt crisis doesn’t really do it justice. The International Monetary Fund (IMF) is now involved, which means the imposition of some kind of austerity program. Once the IMF is on your doorstep, nothing good happens. Harvard professor, former IMF chief economist, and resident genius Ken Rogoff describes it this way:
The Fund does not bestow gifts; it only offers bridge loans to give bankrupt countries time to solve their budget problems. Although countries occasionally can grow their way out of debt problems, as China did with its 1990’s banking crisis, bankrupt countries usually face painful budget arithmetic. Short of default and inflation, most countries are forced to accept big tax hikes and spending cuts, often triggering or deepening a recession.
To be fair, the Fund’s reputation for imposing austerity is mostly an illusion. Countries usually call in the IMF only when they have been jilted by international capital markets, and are faced with desperate tightening measures no matter where they turn. Countries turn to the Fund for help because it is typically a far softer touch than private markets.
But gentleness is relative. It will be very tough – not only for Greece, but for all the other overextended countries of Europe – to tighten fiscal policy in the midst of recession without risking a deepening spiral. Simply put, no one wants to be the next major IMF supplicant.
Nor does the IMF’s arrival mean that bond holders are off the hook. As Qian, Reinhart, and I document, there have been numerous instances in which countries enter IMF programs but end up defaulting anyway. The most famous case is Argentina in 2002, but other recent examples include Indonesia, Uruguay, and the Dominican Republic.
The picture is not a happy one. There is a likelihood of recession triggered by spending cuts and tax increases-and there are plenty of case where the country ends up defaulting anyway.
The U.S. is not immune from the European situation, given all of the linkages through foreign trade and currency exchange. And, frankly, the U.S. debt situation is not as different from the European one as we might like to think. Sooner or later, the U.S., too, will be forced by the financial markets to embrace some kind of austerity program-probably not sooner, but one never knows. Congress will try to delay the time of reckoning by raising taxes and/or reducing spending, but that is never an easy political task.
How should investors respond to all of this? At the present time, U.S. markets are much stronger than international markets, largely as a consequence of the stronger dollar. (Six months ago, the situation was totally reversed!) We’ve noticed that real estate has gained a strong footing in our Global Macro account due to its high relative strength. (Six months ago, there was a strong commodities focus.) In other words, an investor’s source of return may not be the same from period to period. As things continue to change rapidly, I think it is imperative that investors have a systematic way to adapt their portfolios to the changes. Trying to guess what might happen next seems like a losing proposition to me-who had any idea about Greece a year ago? A systematic approach eliminates the need to guess and just deals with what is happening now. Given everyone’s inability to forecast what might happen given all of the intricate and sometimes hidden linkages between world economies, a systematic solution incorporating relative strength may be the most practical.
Click here to visit ArrowFunds.com for a prospectus & disclosures. Click here for disclosures from Dorsey Wright Money Management. Past performance is no guarantee of future results.
