Policymakers' thinking about how best to solve the Greek crisis has certainly evolved. Initially, they provided a loan to reduce Greece's prohibitive funding costs and in return, Greece committed to measures designed to reduce its deficit, such as cutting government spending and raising taxes.

However, it soon became clear that the debt burden was so high that some portion of it would need to be forgiven. The question was when. At first the answer was later, because that bought time for the Greeks to move closer to a primary balance, where tax revenues match non-interest expenditures, for the Spanish to recapitalize their regional banks, for the Portuguese and Irish to improve their fiscal situations, and for the private sector to reduce its exposure to Greek debt.

Unfortunately, events quickly overtook policymakers. Diminishing growth prospects stymied hopes of genuine fiscal improvement. Greece consistently missed its deficit targets, making it increasingly difficult to disburse further tranches of the loan. Resistance grew both to further disbursements in the donor countries and to further austerity in Greece.

Moreover, the inevitability of a debt restructuring, combined with uncertainty about the process and timing, did not sit well with investors. They reacted by selling the sovereign bonds of other eurozone nations, raising funding costs throughout the region. Suddenly, forgiving some portion of Greece's debt sooner than later appeared to be the better option.

The current plan is to provide debt relief to Greece while containing any fallout from the process. Relief takes the form of a bond exchange program, where Greek debt is "voluntarily" swapped for a fully collateralized security worth 50% of the original. This program provides Greece with as much as 103 billion euros of immediate relief and eliminates participating investors' exposure to Greece. Measures to limit contagion include requiring banks to boost their capital ratios, providing guarantees on some unsecured bank liabilities and boosting the lending capabilities of the European Financial Stability Fund.

Thus, there is a plan for dealing with countries deemed insolvent and requiring relief. Greece is likely to adopt it first. Portugal, and perhaps even Ireland, might follow in the not-too-distant future.

However, there is no such plan for dealing with the high funding costs currently afflicting Italy, Spain and France. Some of the actions taken to help Greece may have exacerbated the problem. By insisting that the 50% haircut be voluntary, for example, authorities reduced the efficacy of credit default swaps, leading to additional selling of sovereign bonds.

All roads to a solution appear to run through the European Central Bank, the only institution able to purchase a (theoretically) unlimited amount of sovereign debt. However, it is unclear if the ECB will fulfill this role. Its decision may well determine the near-term viability of the eurozone.

The euro region's long-term viability depends on structural reform. Although the immediate trigger was the deterioration of Greek public sector finances, the seeds of the debt crisis were sown by the decision to form a currency union in the 1990s, a decision that ignored a number of economic realities.

For such a union to be successful, the economic performance of participants must converge, not diverge. This requires flexible labor markets and a system of fiscal transfers to compensate for the inevitable differences in participants' competitiveness.  

Unfortunately, linguistic and cultural differences restrict labor market mobility. Moreover, there is no system of fiscal transfers within the eurozone, at least of any magnitude.

These flaws are serious enough for us to question the viability of the current structure in the long run. Policymakers need to decide whether currency union was a step too far and retreat—the difficulty of which should not be underestimated—or they need to go all in and accept closer fiscal union and supra-national governance. The latter is where we think Europe will go, but getting there will not be easy. 

Payroll Gains Still Stall

Milton Ezrati
Senior Economist and Market Strategist
Lord Abbett & Co.

Employment gains of late have taken the edge off people's worst recessionary fears, but they nonetheless remain fundamentally inadequate, far short of historical norms and the very human needs of the now huge army of unemployed.

In the coming year, continued economic growth should improve the situation, but only marginally. Employment increases will emerge only slowly. By year-end 2012, more than 8% of the workforce will likely remain unemployed. By almost any standard the current cyclical recovery has disappointed. Labor markets especially have suffered. After deep jobs cuts during the 2008-2009 recession, business continued to lay workers off for more than a year into the recovery that officially began in June 2009. The unemployment rate, which had already risen to over 10% of the workforce, stayed close to that terrifying height until very late in 2010. Though hiring began to pick up in 2011, the pace still crawled, rising barely over 130,000 positions a month on average, far below the 300,000 to 400,000 a month averaged in past cyclical recoveries. Unemployment remains atypically high at over 8.5%. (See accompanying chart.) By late 2011, the nation's payrolls still stood some 6.3 million below their pre-recession highs.

Sadly, much of what has caused this disappointing performance promises to remain in place in the new year. Real economic growth, the ultimate driver of jobs, will almost surely stay sluggish in 2012. Housing shows no signs of growth and offers little reason to look for an upturn over a 12-month horizon or longer, for that matter. Consumers should remain cautious, and, though they will likely increase spending, they should do so only modestly. Financially beleaguered state and local governments may cease their most severe cutbacks, especially as their tax revenues slowly expand with the economy's modest growth, but they nonetheless will have to hold back on spending. The federal government will find itself increasingly compelled to restrain its spending as well. And though business acquisitions of new equipment and export sales remain robust, these areas alone cannot offset the sluggish picture elsewhere in the economy. While the United States will almost certainly avoid a second recessionary dip, real gross domestic product (GDP) will at best register an atypically slow 2% to 2½% rate of expansion for the year.

Hiring will likely suffer still more from the legacy of extreme caution haunting business after the financial crisis and recession. Of course, every recession has its lingering effects on business, but this one was particularly severe. Many companies in 2008-2009 were unable to finance even daily operations, and when they turned to their usual sources of credit, they found those lines denied or curtailed. Having suffered so acutely, they now seem determined to hold huge precautionary cash balances on their balance sheets and generally resist any increase in expenses, including hiring. Uncertainties surrounding the European debt situation, growth in China and Washington's fiscal direction have only exacerbated their constraining caution.

Business also has had to cope with the legacy of Washington's past ambitious legislative calendar. Whether or not one approves of the Dodd-Frank financial reform legislation or the healthcare reform law, none can mistake that each introduces tremendous uncertainty and makes it more difficult than ever for business to plan. These laws are so comprehensive and complex that even today, months, indeed years after they passed into law, no one can reliably estimate the expenses involved in a new hire or the future availability or cost of credit. What is more, it will take years before all the provisions become well enough understood for businesses to forecast costs confidently. In this long meantime, the uncertainties will make managers and other decision makers that much more reluctant to expand, including hiring.

The net effect of all these influences, even in the absence of further shocks to the system, should keep payroll gains in the range of 250,000 to 300,000 a month at best. If a pickup from the past year, these figures are still smaller than in past recoveries. And since the workforce naturally grows at about this rate, it would be ambitious indeed to look for the unemployment rate to fall through 8% in 2012.

Nearing a Housing Recovery?

Chris Rupkey
Chief Financial Economist
Bank of Tokyo-Mitsubishi UFJ

It became more difficult in the closing weeks of last year to forecast the year ahead. There is a lot of uncertainty in the world. Even healthy countries are worried about external events over which their monetary and fiscal policies have little control. European leaders first announced a measure to safeguard financial stability way back in May 2010, but here we are with the sovereign debt crisis spreading to Italy and Spain and new questions about whether the European Financial Stability Facility is properly funded and indeed, whether the euro, the currency shared by 17 nations, will survive.

The uncertainty of the situation in Europe, 21% of the global economy, has rattled financial markets around the world. A weakened stock market from a collapse in the euro would turn any upbeat forecast for U.S. economic growth this year into a modest expansion at best. This does not even account for what might happen to American exports, 18% of which go to Europe, if that continent goes into deep recession. But in our 2012 outlook for the U.S. economy, we will focus on the internal dynamics of this expansion from recession.

To move ahead, we must first fix what is wrong—what originally got us into this weakened economic state. Fed Chairman Ben Bernanke said it best when, in early 2009, he cited the bursting of the housing bubble as the "proximate cause" of the recession. The rise in delinquencies on subprime mortgages inflicted substantial losses on financial institutions and drove the stock market down, while the credit markets largely stopped functioning properly. Housing is where the recession started, and Washington has been unable to fix this important sector of the economy yet.

Housing starts for both single- and multi-family dwellings peaked at a 2.2 million annual rate in January 2006 and hit an annual rate of barely 600,000 near the end of 2011. This collapse in housing construction alone dragged down real GDP by 1.1 percentage points in 2007 and another 1.1 percentage points in 2008. Home prices are still falling. Existing home prices nationwide were $230,000 in the summer of 2006 and just $160,000 currently. This 30% price drop has taken a toll on consumer confidence and may have led to a deeper and longer recession.

So in 2012, how do we fix housing, which has slowed the pace of economic expansion since the end of the recession in June 2009? We are cautiously optimistic that housing will gain traction as the year progresses. Some say things are different this time. Recoveries from financial crises are weak and vulnerable to external shocks that may trigger double-dip recessions, they say. We don't know about that, but things are different this time for construction workers. From the peak of the housing bubble, more than 2 million construction workers lost their jobs. If this had not happened, the unemployment rate would be 7% today, not stuck near 9%.

Why are we cautiously optimistic? Some in Washington want to wind down the housing agencies Fannie Mae and Freddie Mac and let the market go back to providing financing for the housing markets. We aren't sure that banks want to relearn how to originate mortgages and keep them on their books again. Still, our basic case for optimism is that the housing markets have undergone their correction, and activity in construction, home sales and even housing prices are either at bottom or very near the low for this cycle. Most of these indicators, like housing starts, hit bottom in early 2010. Time goes on, the U.S. population has grown 2 million per year for the last three years, and eventually this population growth and the formation of new families will allow housing construction to rise from the ashes.

Our forecast for real GDP this year is for an above-potential 3.2% rate, even as the Federal Reserve has revised down its forecast to just 2.7%, from a 3.5% forecast this summer. There is not tremendous pent-up demand for housing, as there might be for auto sales, given that foreclosures remain high. But the worst is now over and the recovery in housing has begun, and this bolsters our base case scenario for above-trend growth for the coming year.

For a previous outlook on the U.S. economy published in the July-August 2011 issue, see Wobbly But Still Standing.