There are 3 main fears driving the current stock market decline. I think each of them may materialize, but either the odds are against them being serious impediments to future growth, or the impact of their occurrence is exaggerated. This discussion therefore focuses on those reasons:
Risk 1. Europe The fear is that Greece will reject the EU deal and drop out of the Eurozone, thereby triggering the same from Portugal, Italy, Ireland and Spain. Any significant part of that avalanche would destroy the euro and severely damage the entire European economy, plunging Europe into a major depression.
I think that the new Greek government and the Germans will not chase each other over this cliff, but rather the deal previously made will get adjusted. Basically, the German and French banks are now eyeball to eyeball with the Greek people, and I think I just saw Merkel and the German voters blink. Moreover, an adjustment would be appropriate. The current deal is based on a moralistic view of what happened in Greece and how Greek public employees, tax avoidance, and corruption are to blame for the mess. Consequently, the northerners felt justified in imposing economically senseless austerity requirements. In reality, I think the bankers who made loans without evaluating risks properly are just as blameworthy, and therefore the draconian requirements of the Greek deal are severely unfair. That moves the issue from morality to politics, where fairness is a major concern. And the political reality is that if the northerners want to save the euro, which has been tremendously beneficial for them, they must bow to political reality and make a fairer deal. They seem to be moving that way, and since they have more to lose by refusing, I am pretty sure they will do so.
Even if the Greeks do drop out, the direct impact on the rest of Europe would be minor. So, that leads us to the contagion issue. The other countries at risk are very different than Greece. They do not face the same moral onus, and of course the risks to the northerners are much, much greater should the defaults spread. Accordingly, especially in light of the very substantial funds that have been allocated to protecting Europe from further financial disaster, I think the possibility of continued demands for austerity, and contagion, is quite low. There will, of course, be much shouting and finger pointing, and the words could get ugly, but in the end I still think the northerners will cut a deal that the southerners and Irish regard as fair.
Bottom line: I think there is only about a 15% chance that Europe will swirl itself into a new depression.
Risk 2: China The risk here is that China’s growth rate slows and, longer term, that China’s potential political, environmental, and economic difficulties become unmanageable. In other words, that it ceases to be a growth engine for the world.
Although China is huge, and manufactures an enormous amount of what the world consumes, it is not as economically important to the world as its population and manufacturing capability would indicate. It consumes far less than its size, population, and manufacturing prowess might indicate. Moreover, short of civil war, a most unlikely possibility, China’s slowing growth rate would have little effect on the manufacturing sector as far as the rest of the world is concerned. And if necessary, much of that manufacturing could quickly shift to other countries, including the US, as it certainly will anyway over the next couple of decades. China is a huge factor in world trade because of its manufacturing sales abroad, and the shipment of materiel into China to support that manufacturing. But as a market, China remains much smaller.
The Chinese economy, slightly larger than Japan’s in GDP ($5.9 trillion to $5.5), depends much more heavily on trade. Specifically, its imports total $1.587 trillion compared to $2.592 for the EU and $2.336 for the US. Most of what it imports, however, goes back out in exports. As WTO data notes, Trade is 55.2% of China’s GDP compared to 29.8% for the EU and 27.8% for the US. By contrast the consumer markets in the EU and the US are much larger, with GDPs of $16 and $15 trillion compared to China’s $6 trillion. Back out the share of GDP represented by trade and the differences are even greater: $11.23 trillion for the EU, $10.83 trillion for the US, and $2.69 trillion for China. So while a serious slowdown in China seems 50% possible, and would have an impact, the impact would not prove especially large or scary.
Risk 3: Congress The third, and in my estimation the largest risk of all, is that US politics will prove extremely destructive to the economy. The risk comes basically from gridlock on two matters. First, if Congress fails to decide on the debt ceiling in a timely way, it will create major uncertainties for domestic and foreign firms, causing a serious decline in investment spending, perhaps private consumption, and public tax revenues and spending. Second, the draconian tax increases that would take effect if the politicians cannot reach a budget agreement would significantly reduce US purchasing power, a problem exacerbated by reductions in public spending at both state and federal levels. The impact on perceptions and the willingness of firms and consumers to spend (a failure of economic demand that leads to depression) could be even greater. It is hard to estimate the severity of the economic decline that these failures would trigger, or even the timing, but given the track record of Congress, the positions the candidates and politicians are announcing, and the ideological fervor that many are showing, the risk seems quite large.
As with Europe, however, I cannot believe that the politicians will pursue insanity to the ultimate degree of economic destructiveness. With a Presidential election looming, I think their incentives cut both ways. That is, the Republicans would like the economy to slump because it would hurt Obama’s election chances. On the other hand, they don’t want the blame by appearing intransigent. My best guess is that they will find compromises to “kick the can down the road” and let the election and the next President handle the issues. In other words, they will not let economic catastrophe overwhelm their candidate’s chances at the end of 2012. Consequently, I rate the possibility of economic disaster occurring in the near future because of Washington gridlock as no higher than 50-50. But this is the only one of the three main present risks that I find gravely troublesome.