American manufacturers are enjoying a moderate recovery, but Europe’s financial crisis poses a great risk to both factories and the wholesalers who are both up-stream and down-stream from them.
That recovery is shown by an increase of manufacturing output, up 16 percent from the bottom of the cycle in mid-2009. Total wholesale sales have grown much more, but a good portion of that reflects a more than doubling of oil and gasoline prices. However, the bad news is that industry has not grown nearly enough. The level of production remains over seven percent lower than at the previous cycle peak back in late 2007.
What risk does Europe pose for further improvement in manufacturing and industrial distribution? The risks are two-fold: loss of exports as Europe falls into recession, and collapse of spending here in North America due to contagion if the crisis spreads to our financial institutions. I believe these risks are significant, though not at all certain to occur.
European economic activity is certainly slowing, with drops in total industry production in most of the major economies there. Worry about the financial crisis is dampening spending by businesses and consumers both. It is unlikely that the Euro zone will avoid at least a mild recession. Already our exports are dipping, after years of helping to propel the economic recovery.
American manufacturers and their suppliers should worry in proportion to their export volumes to Europe. There will certainly be specific products that are in fashion and specific companies that weather the storm much better than average, but overall it will difficult to maintain last year’s sales volumes to European customers.
If Europe manages to muddle through the financial crisis—which is the most likely case—then American producers will face only a mild slowdown in sales to the Continent. However, there’s a chance of a real financial meltdown triggered by the weak credit of Portugal, Italy, Greece Spain: the PIGS. This type of crisis typically hits private credit flows as well as government bonds, stifling spending by consumers and businesses. In this event, exports from the United States and Canada will plummet, not only from loss of unit sales but from price cutting as well. We would also feel an “echo recession,” in which our largest Asian trading partners go into a slump from lost sales to Europe. As with all echoes, though, it is milder than the original tone.
A real melt-down of the European financial system could have another significant consequence for American manufacturers and wholesalers: a collapse of lending, and thus spending, on this side of the Atlantic Ocean. Financial crises often spread from one location to another in a phenomenon called contagion. A loss in one market makes financiers get nervous about all other markets. They hunker down, denying loans to everyone. At that point, spending has to slow dramatically, even in sectors that were not originally the problem. Could contagion spread a financial crisis into American markets?
Let’s first understand the problem we had back in 2007 and 2008. Our financial system had become multi-layered, and required each layer to function smoothly to get credit from the saver to the end user. Bank loans exceeded bank deposits. Banks and other lenders were securitizing all kinds of credit, business and consumer loans as well as mortgages. Third party guarantors assured everyone that risk was low.
When the financial crisis occurred, credit froze up at various steps in this process, and the third-party guarantees were doubted. New credit issuance came to a standstill.
Would history repeat itself in the United States if Europe’s financial system flamed out? I think not. Our banks are now lending out only 80 percent of their deposits, down from over 100 percent in the boom. Securitization of non-mortgage loans is small. A much greater portion of our total credit is plain vanilla: a depositor puts money in the bank, and the bank lends the money to a business. It’s simple and much less prone to sudden halts from panic. There are no guarantees, of course. The financial system is too murky for anyone to be sure what will happen, but I’m fairly confident that our risk is from our exports, not from our financial system.
Thus, manufacturers and distributors of industrial parts should do contingency planning for a European recession. My best guess is that Europe will muddle through, but the risk of a real recession on the Continent is too big to ignore.
For more help on how do the economic contingency planning needed with this economic environment, watch my videos, Economic Contingency Planning with risk of recession: