In case you've been living under a rock, the U.S. stock market has been taking it on the chin over the past two weeks. Despite their rallies today, the Dow, Nasdaq, and S&P 500 are all still down over 10% from their post-financial crisis highs. The media is blaming two main factors for this decline. The first is the downgrade of U.S. government debt from AAA to AA+ by the credit rating agency Standard & Poors. The second cause that political and financial pundits have identified is the European currency and sovereign debt crisis that recently came to a head when it spread to Italy. Unlike Portugal or Greece, Italy is a major player in the global economy, and it has a large enough debt to bankrupt the European Financial Stability Facility (European sovereign debt TARP) if it needs a bailout.
I think the talking heads are partially right and partially wrong on both counts. First, the painful sell-offs began on August 1 with the announcement of a bad ISM number (an important manufacturing index) and downward revisions of U.S. GDP growth figures for the first two quarters of 2011. If I recall correctly, by the time the decline accelerated last Thursday and Friday, August 6 and 7, the markets had already been down six days in a row. The U.S. debt downgrade is not the cause of all our woes. It's merely the straw that broke the camel's back. Investors had been preparing to sell for over a week based on a host of negative economic indicators. The relationship between the debt downgrade and the market correction is more correlative than causative. Both occurred because the economy sucks and neither the government nor private individuals can stay afloat financially.
The pundits are spot-on about the European crisis being another cause of the market meltdown, though. Here's the deal: several European countries, namely Portugal, Italy, Ireland, Greece, and Spain, are up to their eyeballs in debt. Most of the big European banks own significant amounts of this debt and have made loans and other investments using this debt as collateral. If these countries can't pay back their debt, though, the value of the bonds the banks hold becomes worthless, the banks' total assets drop, and they run the risk of failing and taking the entire European financial system down with them. It's like the U.S. mortgage-backed security crisis all over again, except with countries not paying back their loans instead of homeowners.
What does this have to do with the U.S. economy? Well, to put it simply, the U.S. sells a lot of stuff to Europe. The economies of all the European countries put together are bigger than that of the U.S. or China or any other individual large economy. If a big chunk of the global marketplace becomes financially paralyzed, that could harm the U.S. by reducing the number of buyers for our goods. All things considered, though, with the rise of China, Brazil, and other low-wage exporters, the United States economy is nowhere near as dependent upon exports as it used to be, so the damage we would incur from a European financial crisis, though severe, would be limited to a particular sector of the economy.
The real problem we face is that large, export-driven multinational companies, the kinds of companies that would really suffer in the face of a European recession (and possibly emerging market cutbacks as Asian and South American exports to Europe fall, too), are the only companies that are growing and powering our economy right now because the U.S. domestic market sucks. Unemployment is high, prices are high, and wages are stagnating. The domestic market is still the main driver of U.S. production, and until that turns around, we're gonna be mired in the muck. What is keeping America's economy down? Stay tuned for my next post to find out.