America keeps low profile in Europe

This is my Fund Strategy Perspective column for 5 March.

Last week’s column examined the relationship between the eurozone crisis and China. This week the focus will shift to the connection between the region and America. The subject is particularly poignant given last week’s refusal by the G20 group of finance ministers to contribute more to European bail-outs.

Once again there are two sides of the relationship to consider: the likely impact of eurozone turmoil on America and Washington’s capacity to help bail out the eurozone in the event of further instability.

There is no doubting the official line. At diplomatic events the two sides play up their role as the largest economic blocs in the world as well as emphasising their common culture heritage.

A White House summit last November featuring Barack Obama, Herman Van Rompuy, the president of the European Council, and Jose Manuel Barroso, the president of the European Commission, ended with the following statement:

“We, the leaders of the United States and the European Union, met today at the White House to affirm our close partnership. Drawing upon our shared values and experience, and recognizing our deep interdependence, we are committed to ensuring that our partnership brings greater prosperity and security to our 800 million citizens, and to working together to address global challenges.”

But talk is cheap. A closer examination of the relationship between the two sides reveals that in many respects their closeness is exaggerated.

It is striking that there has been much more debate about China, rather than America, bailing out America. The obvious explanation would be that China has a lot more spare cash, with its immense foreign exchange reserves, but this is misleading.

For a start the American economy is still over twice as large as that of China in absolute terms. In terms of income per head, even when adjusted for cheaper prices in China, the average American is more than six times richer than the average Chinese.

Moreover, America has played the role of undisputed world power since the second world war. Its unwillingness and inability to play such a role in relation to the eurozone crisis is telling.

In relation to trade it is true that the eurozone (a smaller entity than the European Union let alone Europe) is the destination for 15% of American exports. But the official figures from the United States International Trade Commission show closer trade links, taking into account both exports and imports, with the rest of the Americas and with East Asia.

America’s largest trade partner is Canada with Mexico at number three. China is its second largest partner with Japan at number four. The largest eurozone partner is Germany, at number five, while Britain, not a member of the eurozone, is at six.

If all the East Asian countries were clustered together they would account for a high proportion of American trade. Apart from the big two, South Korea is at seven, Taiwan at nine and Singapore at 16.

It should also be remembered that, relative to its size, America is not a particularly large trading economy. It is focused much more on domestic production and consumption. The effect of a sudden drop in, say, eurozone exports to America would probably only be marginal.

Europe is responsible for the bulk of foreign direct investment (FDI) in America. According to figures from the Treasury department it accounts for $1.6 trillion (£1 trillion) or 70% of the total stock of American FDI. But such investment is normally invested for the relatively long-term so a renewed European crisis would probably not lead to a rapid withdrawal.

The most likely channel for the eurozone crisis to disrupt American economic activity is through short-term financial linkages. If a eurozone country defaulted or exited the currency bloc it could even lead to a market panic.

Such concerns are the remit of the Financial Stability Oversight Council; an organisation within the Treasury department established under the Dodd-Frank Act of 2010. Its 2011 annual report came up with the following assessment:

“While U.S. financial institutions’ direct claims on peripheral euro area borrowers are relatively modest, their exposures to core European banks in the United Kingdom, Germany, and France are much larger, and those European banks are the primary international lenders to peripheral European borrowers. The interconnectedness of financial institutions with sovereigns makes it difficult to precisely quantify all possible exposures, which in turn increases the risk that a credit event could lead to generalized declines in investor sentiment, losses of liquidity, and associated disruptions of international financial markets.”

So from this perspective the main danger is not the direct effect of a financial crisis in, say, Greece or Portugal. It is that a crisis in the eurozone periphery affects core European banks and eventually sparks a generalised market panic.

From this brief examination it is possible to draw some tentative conclusions about the state of the relationship between Europe and America.

First, the state of America’s domestic economy is likely to be a key determinant of the impact of eurozone instability. The relatively small scale of its trade means America should be able to weather a European crisis unless its domestic economy is weaker than appears. A more likely channel to spread instability across the Atlantic is through short-term financial flows.

But the most striking change in recent relations between the two sides is political rather than economic. Despite a few summits the American leadership has played a low profile role in relation to Europe. If anything it is steadily shifting its priorities towards Asia. Perhaps short-term financial expediency has come to the fore in America but it still suggests the world is in the midst of an important transition.