Fears of a developing sovereign debt crisis in Europe started in late 2009, but the situation became particularly tense in early 2010. Crisis Europe included eurozone members (Greece, Ireland and Portugal) and also some European Union countries from outside the eurozone. In the EU, particularly in countries where sovereign debts have increased strongly due to bank bailouts, a crisis of confidence has emerged. The sovereign debt has become a perceived problem for the area as a whole. The crisis resurfaced in May 2011 and focused on the refinancing of Greek sovereign debts.
The fears have been extended to concerns about rising government deficits and debts across the globe, accompanied with downgrades of European government debts. This worsened situation has created alarms in world financial markets and expectations of recession in developed countries including the United States. This essay analyzes briefly the impact of European crisis on the American economy. The analysis will focus on the impacts on American banks, exports and wealth, and the contagion effect.
1. Impacts on U.S. Banks
The U.S.’ gross direct exposure to European banks through loans and bonds amounts to $678 billion. This does not include less direct exposure through financial derivatives, loan guarantees and other financial connections such as credit default swaps such as CDSs.
While a collapse of a European bank as major as Societe Generale or BNP Paribas will not have much impact on the U.S. economy, a financial contagion in Europe will, however, have a palpable impact on the U.S. and the global financial system through the loss of confidence in banks.
2. Debt Contagion
The financial markets across the Atlantic are highly integrated with each other and are highly susceptible to contagion. If the Greek debt crisis spills over into larger European economies such as Italy and Spain, this will reverberate into the European core countries: Germany and France. The U.S. banking sector has the largest exposure to the core European countries. Recently the Fed underscored the fact that big U.S. banks remain vulnerable to Europe’s financial contagion. The U.S. banks that are likely to be exposed to this contagion are J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley.
Exposure of these five big banks to France and Germany, along with smaller eurozone countries, is equal to about 81 percent of these banks’ combined Tier one common capital. In particular, exposures of these banks to Ireland, Italy and Spain are equal to about 25 percent of the banks’ combined Tier one common capital.
3. Euro Devaluation
The European sovereign debt crisis will trigger a devaluation of the euro against the U.S. dollar, which would impact U.S. exports. Europe is the largest export market for the United States. Depreciation in the euro will make American exports to Europe more expensive, which would significantly weaken the only remaining engine of growth for U.S. economic recovery after the U.S. government ended its stimulus package. Total U.S. exports accounted for more than one-third of American economic growth in 2010 and helped the economy recover from the Great Recession.
4. Threat to Euro Viability
The weakening of the euro versus other global currencies and spread of contagion from small European countries, such as Greece and Portugal, to the larger countries, such as Germany and France, may threaten the viability of the euro, potentially paralyzing global credit markets in a way similar to what happened after the collapse of Lehman Brothers.
5. Loss of Wealth
The European crisis has affected U.S. capital markets other than the banking sector. It has unraveled stocks and increased fears of a new crash in the stock market. The crisis has also jolted hopes of a strong recovery in the United States. There could be a global loss of wealth, one way or the other, and the loss could be huge.
In conclusion, contrary to the old saying “What happens in Vegas stays in Vegas,” what will happen in Europe may not stay in Europe. The new recession in the U.S. economy may come this time from Europe. If and when it happens, it may be called “Great Recession II.”
Shawkat Hammoudeh is a professor of economics. He can be reached at email@example.com.