How to Profit From Europe’s Stealth Economic Recovery

By: Money_Morning

Martin Hutchinson writes: European countries - both inside and outside the Eurozone - are slashing their budget deficits.

Greece, Portugal and Spain - three of the so-called "PIGS" - have to do so, of course. But Germany - generally reckoned to be in excellent shape - is also cutting its deficit, as is France, which hasn't run a budget surplus in 40 years. Britain, too, with no need to protect the euro (it's not a Eurozone member) just introduced a budget that cut the deficit by $140 billion over four years.

U.S. President Barack Obama and other Keynesians warn that Europe may push its own economy - or even the global economy - back into recession.

But here's the surprising reality: Europe may gain from its fiscal pain - and its deficit-trimming actions offer the best hope for a lengthy recovery.

A Flawed Theory
The Keynesian theory of economic "stimulus" rests on the flawed fundamental belief that government spending can create wealth. The fact is that just the opposite is true.

In reality, the money the government spends has to come from somewhere. So any jobs "created" by government spending are matched by other jobs - possibly more of them - lost somewhere else in the economy. It's part-and-parcel of the so-called "crowding-out" effect.

If financing is plentiful and state budgets are in surplus - or only experiencing small deficits - a burst of "stimulus" may offset a recession. If budget deficits are already large, or financial conditions are tight, the government job-creation may be more than offset by job destruction in the private sector - generally the small-business private sector - that is then starved of funding.

The considerations aren't merely financial - there are also "confidence" concerns. The decline in value of subprime mortgages and other bubble-era assets accelerated sharply when confidence in those assets collapsed. Once that occurred, mortgage lending became much tighter and home mortgages might have become impossible to obtain for a period - had the government not intervened with guarantees.

Similarly, when confidence in Greece collapsed, that country's cost of borrowing escalated rapidly. It wasn't long before Greece was no longer able to tap the capital markets, forcing it to obtain a bailout from its rich friends in the European Union (EU).

If that can happen to Greece, it can happen to anyone elsewhere. Very large budget deficits disproportionately increase the chance of a collapse in confidence in the country concerned. It becomes impossible to raise money for viable private sector projects. The Keynesian "multiplier" theory - which holds that unemployment itself reduces consumption and investment - shifts sharply into reverse.

The ultimate impact: Once a deficit gets beyond a sustainable point, its long-term costs far outweigh any potential benefit that the "stimulus" was supposed to create.

The Outlook for Key Markets
So where does that leave us with Europe? Well, in this seemingly paradoxical reality, as European governments rein in their budget deficits, they may actually increase the strength of their economies.

For those countries with large debts or deficits - such as Spain, Portugal, Italy and Ireland - the deficit reductions are necessary in any case to restore confidence in the economy and reopen the flow of funding to the private sector. With Greece - admittedly the most extreme case - this may not be possible: The combination of a feeble economy and a corrupt, kleptocratic government may simply make the place unattractive for many years to come.

For Germany, the reduction in borrowing is less necessary, but the weakness of the euro should prove hugely beneficial for Germany's major exporters. Thus even if the transfer of resources from Germany's relatively efficient public sector to its private sector does not boost output directly, the surge in Germany's exports should further strengthen that already-strong economy.

The two intermediate cases are Britain and France, where the combination of debt and deficits is alarming, but not immediately threatening. In both countries, the main problem has been the inexorable growth of the public spending - to 52% of gross domestic product (GDP) in Britain and 56% of GDP in France.

In Britain, the massive cuts in public spending now announced should revivify the economy, although the overhang of excess capacity in financial services remains worrisome.

In France, moves to raise the state-sector-retirement age to 60 - still nowhere near enough for long-term fiscal balance - can only help output by removing a little of the drain on the private sector.

Profit Moves to Make Now
For U.S.-based investors like us, the course is clear. Quite apart from our investments in the growth economies of Asia and emerging markets, we should look more closely at Europe - for at least the following three reasons:

•Europe's oversized state sectors are being trimmed.
•The region's growth may now accelerate somewhat.
•And - in contrast to the United States - Europe is reversing the mistaken "stimulus" policies of recent years.
Germany, in particular, is attractive, and no portfolio should be without some German shares, or possibly the MSCI Germany ETF (NYSE: EWG). For overall exposure to the countries using the euro, there is the iShares MSCI EMU Fund (NYSE: EZU).

Source : http://moneymorning.com/2010/06/25/europe/

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