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Reader "Bill" asks "Will we catch the Euro contagion?" The Eurozone economies now appear to be in a recession, and the UK economy is also. It seems valiant to assert that the U.S. will avoid catching this double-dip Euro recession flu, but so far that is exactly what we have been doing. In fact, we've avoided catching this flu for the past 18 months, thanks to a fundamentally healthier outlook for the U.S. economy. Here are some charts to prove my point (click to enlarge):

Let's start with swap spreads, excellent and leading indicators of systemic risk. This chart shows that the U.S. first decoupled from the Eurozone in mid-2009, as U.S. swap spreads fell while Eurozone swap spreads rose. We got a hint of contagion in the second quarter of 2010 when all swap spreads spiked (in response to the first eruption of sovereign default risk), but U.S. spreads quickly settled back down. We saw another hint of contagion in the second half of last year, as the Greece default disease reached its climax, but once again the U.S. fundamentals improved even as Eurozone conditions remained fragile. U.S. swap spreads are still firmly within a "normal" range, but Eurozone swap spreads are still quite elevated. The Eurozone has avoided a financial meltdown-thanks to aggressive easing by the ECB - but default risk remains high because too many countries in the Eurozone have bloated governments that are strongly resisting the need to go on a diet. Capital flight, the risk of increased tax burdens, and fears of a Euro breakup have weighed heavily on European economies.

Comparing the performance of U.S. and Eurozone equities (above chart), we see that the true decoupling of the U.S. and the Eurozone began in 2010, as U.S. equities marched irregularly higher, while Eurozone equities marched irregularly lower.

The chart above shows the ratio of U.S. equities to Eurozone equities. Since early September 2010, U.S. equities have outperformed their Eurozone counterparts by over 50%. That's a pretty solid indicator of just how immune the U.S. economy has been to catching the Eurozone flu. It's actually very impressive.

To be fair, I should acknowledge that the U.S. has benefited significantly from the dollar's reserve status: with the future of the Euro in doubt, the dollar becomes the default currency for just about anyone seeking a safe haven these days. The U.S. economy has indeed benefited from significant capital inflows from Europe, as the above chart suggests.

Moreover, even though the U.S. fiscal picture is not much better than the Eurozone's in aggregate (all major economies have a severe over-spending problem it seems), the size of our federal debt does not necessarily pose a risk to the dollar, just as Japan's monstrous government debt has not hurt the yen. The same cannot be said for the Eurozone, since national governments there are not free to inflate or devalue their way out of their debt morass, leaving a breakup of the euro as one viable - but not very attractive - option.

The U.S. has one more thing going in its favor right now, and that is the growing likelihood that the November elections will reveal that country is getting serious about attacking its deficits. We have already benefited from a major shift in the balance of power in Congress, and now a change in the presidency looms. To make the point clear: Obama's recent budget proposal called for increased spending, higher taxes, and trillion dollar deficits for years to come, but not a single House Democrat was willing to vote for it. Obama and Harry Reid in the Senate are among the shrinking number of Washington politicians who still believe that the way out of our current mess is to spend and tax even more. Knock one or both of them out and the balance of power in Washington and the thrust of fiscal policy can change dramatically.

One important caveat: there is a good way and a bad way to practice fiscal austerity. Europe so far has been attempting to pare deficits through a combination of tax hikes and spending cuts, but this does not inspire confidence: tax hikes in the midst of a recession are not only politically difficult to implement, they can aggravate the weakness (the U.K. has already abandoned its attempt to boost taxes on the wealthy because it failed utterly to produce higher revenues) and that creates a negative feedback loop that can push deficits even higher. The U.S. is toying with tax hikes, but I don't seen any meaningful chance of that happening. It's far more likely that the U.S. federal deficit will continue to decline relative to GDP (as it has for almost two years now) thanks to spending restraint and continued moderate growth. If the U.S. can achieve some significant tax reform (e.g., broadening the base by eliminating loopholes, deductions, and tax subsidies, in exchange for lowering marginal tax rates, plus cutting the corporate tax rate meaningfully), then the resulting stronger growth could do wonders for deficit reduction.

Another refreshing wind of change blowing through Washington these days is the growing perception that government spending does not stimulate an economy, and can in fact weaken an economy. Keynesian theory has suffered what could prove to be a fatal blow with the failure of the Obama stimulus to boost the economy as advertised. If enough politicians come around to the realization that cutting spending (or at least not increasing it) can prove beneficial for growth, then "austerity" becomes a good thing. I'm not holding my breath for a development like this anytime soon, but I think that on the margin we are moving in that direction. And markets are always very sensitive to change on the margin.

Source: Eurozone Crisis Has Not Proved Contagious