Despite only moderate news coverage, the European sovereign debt crisis is undoubtedly the first item atop President Obama’s morning briefs.
The crisis, which has been ongoing for the past three years, is one that may have a profound affect on the United States and its ability to recover from its own financial crisis.
Despite the understandable tendency of most people to tune out and glaze over when pundits start talking about international monetary policy, the crux of the problems in Europe are fairly simple: some Eurozone countries, Portugal, Italy, Ireland, Greece and Spain (also known as PIIGS countries) in particular, have too much debt and run the risk of not being able to pay their creditors back.
The complexity and severity arises from the interconnectedness of the European economies. Firstly, European banks, especially the German and French ones, hold a lot of debt from the PIIGS nations. So if one of these countries defaults, European banks face huge losses which could devastate the entire economic system in Europe, much in the same way the 2008 financial crisis dealt huge blows to the American economy. Secondly, the fact that all these countries use the same currency means that if one nation defaults it could spark a panic, causing investors to divest in sovereign debt decreasing the Euro’s value, spark a continental credit crunch and increase the cost of borrowing, ultimately leading to further sovereign defaults in Europe and potentially collapsing the European Currency Union.
Conflict among European nations has arisen largely over the fact that the most fiscally responsible states, such as Germany, have had to provide bailout funds and financing packages to irresponsible nations who used the Euro’s high credit rating to borrow and finance unsustainable social programs.
European governments and the IMF have been struggling to address the issues with ever-increasing bailouts, mandated cuts to social programs, and stronger legislative mechanisms to enforce fiscal responsibility in Euro-zone nations.
Because of the uncertainly of the whole situation, it’s impossible to predict the exact consequences for the United States of any of the possible scenarios in Europe.
In a November article, New York Times Economix blogger Catherine Rampell nicely summarizes the potential economic impacts that a catastrophe in Europe would have on the United States.
First and most simply, the American stock market will suffer from a recession in Europe. As we have seen throughout this whole ordeal, the vast number of corporations spanning continents help tie American and European markets to one another. When the European stock markets go up, so to do American ones. When European markets go down, American markets follow and vice versa. A huge dip in European stock markets would no doubt mean an equally severe one for the U.S., which means huge losses for individual shareholders and corporations alike.
Second, trade is severely impacted. A recession (or depression) in Europe means Europeans will buy fewer American goods. As the purchaser of 22 percent of American exports, a decrease in European demand will severely hurt the profits of American exporters. Still, the effect of a European recession on U.S. trade expands outside of the continent. If there is a European recession, the dollar will rise in relative value against the Euro, making U.S. exports more expensive, further decreasing the amount of American goods and services that foreign countries all over the world purchase.
Third and arguably most important are the implications of the fact that U.S. banks hold billions in sovereign debt from PIIGS nations. If a debtor nation in Europe defaults on their loans, U.S. banks stand to lose money which would likely spark a credit crunch (a situation where it is harder and more expensive for American businesses to get loans and lines of credit.) If credit tightens, the economy slows–it is as simple as that. Well not exactly, but if American businesses have a harder time getting credit, they will find it much more difficult to finance investment which is needed for growth and to hire workers. A credit crunch would ultimately set back the American recovery from the 2008 financial crisis an untold number of years.
So what can the United States do to prevent one of Europe’s nations from defaulting and sparking a recession? Unfortunately, not all that much. The U.S. has the ability to provide some lending assistance to the tune of $380 billion via the IMF but ultimately, an economic and more long-term political solution must come from EU governments themselves.
If a true Euro crisis does occur, the U.S. has a number of unpleasant policy options at its disposal that it may need to use to ease an economic crisis. It could provide bailouts to the most troubled nations. The Fed could purchase European sovereign debt or lend to troubled European banks. But with the American economy still recovering, the public still having a bad taste in its mouth from the bailouts and stimulus of the 2008 financial crisis, together with hyper partisanship in Washington, it is unlikely that these options would be either popular or simple to pass.
A deeper crisis in Europe carries significant political implications in the United States. President Obama’s re-election bid is largely riding on a continuing economic recovery. If a European crisis does in fact occur and the American economy slides back into recession, President Obama can kiss a second term goodbye.
Congressional leaders and the Administration would do well to start drawing up a contingency plan should the worst occur. As of now, no such plans are known to exist. According to a December article in the Atlantic, administration officials have privately told reporters that they believe voters do not want to hear the President blaming other nations for the United States’ economic woes. This type of political exercise is exactly the type of nonsense that voters detest and will ultimately prevent this country from maintaining its global economic and political prominence.
With the American economy finally looking like it is truly recovering, officials are correct to worry about the effect that publicly addressing the severity of the situation in Europe will have on consumer confidence. Still, a full scale Eurozone crisis transcends the risk to consumer confidence and to re-election bids. Hoping for the best, but preparing for the worst–whether it be privately or publicly — is still the most sound strategy for American officials to take.