Europe's crisis threatens U.S. economy

The Greek government is on the verge of collapse and Italy is struggling to manage their large amounts of debt. Leaders met to try and stop the financial crisis however their options are limited and whatever they decide could threaten the US economy.

By John W. Schoen, Senior Producer
November 3, 2011

With the Greek government on the verge of collapse, Italy facing doubts about its massive debt, the leaders of the industrialized world met in France to try to stop the financial crisis playing out there from spreading around the globe.

Their options are extremely limited. If the crisis isn't contained, the shocks will be felt more painfully in the U.S.

"The European debt crisis is the single biggest threat to the U.S. recovery and the global recovery," said IHS Global Insight chief economist Nariman Behravesh. "The situation in Europe could spin out of control, as we've certainly seen in the last couple of days. And that could take the U.S. down with it."

Nearly two years after the it began,the crisis is already forcing Europe's economy back into recession, according to European Central Bank President Mario Draghi.

“What we are observing now is slow growth, heading towards a mild recession by year end,” he told reporters in Frankfurt Thursday, on the first day of his new job.

The fate of the European and U.S. economies are linked through multiple ties. The trade relationship is "the largest and most complex in the world," amounting to about $3.8 billion day and generating more than 7 million jobs, according to the Office of the U.S. Trade Representative. Slowing consumer and business spending in Europe means slowing demand for U.S. products and services.

The impact of a deeper European recession would be quickly felt on large U.S. companies that have been reporting strong profits overseas despite a sluggish recovery at home. That could force renewed belt-tightening, prompt layoffs and send the unemployment rate higher.

To blunt the impact of that downturn, the ECB cut interest rates Thursday - by a quarter point to 1.25 percent - as the crisis widened. Greek officials Thursday scrambled to head off a proposed referendum that could force a withdrawal from the Euro and threaten the viability of the common currency. Deep budget cuts and a mass layoff of government workers have sent the Greek economy sharply in reverse. Though France and Germany are demanding further cuts before extending aid to Athens, Greek leaders counter that further cuts are politically untenable.

Other heavily indebted European countries are drifting closer to that economic abyss. On Wednesday, Italy missed a critical deadline to come up with a plan to cut its budget deficit and revive growth. Spain, Portugal and Ireland are wrestling with proposals for similar measures to ease those countries' heavy debt burdens.

As Europe's leaders have proposed, and shelved, multiple solutions in recent months, some observers believe that European leaders have not yet come to terms with the scope of the debt crisis. The latest includes a proposal that holders of Greek debt "voluntarily" agree to see the value of those bonds cut in half. But some observers say the measures proposed so far don't go nearly far enough.

"The Europeans have to come to grips with reality," said former Federal Reserve governor and Columbia University economist Frederic Mishkin.

Mishkin believes that means European leaders need to prepare for a much bigger writedown of Greek debt, along with the larger losses that would inflict on European banks holding those bonds. But it's not clear that European bank regulators have taken the steps needed to make sure the financial system there can withstand those losses.

"This has always been the issue," said Mishkin. "The good news is that the denial phase is starting to go away, and that's critical to finding a successful solution here. Although it's going to be damn difficult to do so."

The threats to Europe's financial system have already rocked U.S. financial markets and sapped American business and consumer confidence. But a wider meltdown could spread rapidly across the Atlantic.

One "transmission mechanism" would be the impact on the U.S. dollar, which remains a safe haven for global investors in times of crisis. Demand for dollar-based assets drives up the value of the currency, imposing a penalty on U.S. exporters.

While U.S. banks and financial institutions are believed to be relatively well insulated from direct default of Greek and other European debt, less is known about the holders of default insurance on those bonds, so-called credit default swaps.

The proposed "voluntary" Greek bond writedown is an effort to avoid an actual default, an event that would trigger billions of dollars worth of swap payments. The fear is that a cascade of losses from issuers of default insurance could spread quickly through the global financial system, much as the collapse of Lehman Brothers sparked the financial meltdown of 2008.

European central bankers have resisted the kind of massive bond buying programs that the U.S. Federal Reserve undertook to calm the financial waters after the Panic of 2008. Thursday's rate cut signaled that Draghi could bring a more aggressive response to the crisis. But some observers see the move as too little, too late.

"Draghi made clear that the Bank will not buy enough bonds to provide the 'firewall' that markets hope might stem the region’s crisis," said Jennifer McKeown, an economist for Capital Economics. "For now then, the euro zone’s fate will remain in the hands of the region’s governments, who appear increasingly unable or unwilling to respond."

As the crisis unfolded Thursday, leaders of the Group of 20 largest economies were arriving in Cannes, France for a regularly scheduled meeting. The agenda will include the search for solutions to the nearly two-year-old crisis.

But President Barack Obama and the U.S. delegation will have little new to offer. As Fed chairman Ben Bernanke told reporters Wednesday, Europe's problems can only be solved by Europe's leaders.

"It is a bit frustrating. ... ultimately it's their responsibility to find solutions to this very difficult problem," he said. "Of course, I and Treasury Secretary (Tim Geithner) and other economic policymakers in the United States do confer and meet with European policymakers on a regular basis and we give our advice, for what it's worth. Sometimes they take it. Sometimes they don't. But obviously, they're the ones who have to make those decisions."

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