A European Economic Tsunami

The European sovereign debt crisis is now entering a critical phase, which U.S. economic policymakers would be ignoring at their peril. For this crisis has the real potential for delivering the severest of body blows to an already enfeebled European banking system. And if there is one thing that U.S. policymakers should have learnt from the Lehman fiasco in September 2008 it is that a banking crisis in a major part of the global economy can have serious economic and financial consequences for the rest of the world economy.

Last month, in a rare moment of candor and realism at the European Central Bank, Jurgen Stark, the ECB's chief economist, sounded the alarm about the potential gravity of the European sovereign debt crisis. He warned that if a country like Greece defaulted on its sovereign debt, it could trigger a banking crisis materially worse than that unleashed by the collapse of Lehman Brothers.

If a country like Greece defaulted on its sovereign debt, it could trigger a banking crisis materially worse than that unleashed by the collapse of Lehman Brothers.

Mr Stark's concern was not simply that a Greek default would all too likely result in contagion to Ireland, Portugal, and Spain. Nor was it that this would have dire economic consequences for those countries' economies. Rather, his main concern was about the potential damage that a wave of defaults in the European periphery would have on the German, French, and United Kingdom banking systems.

For Mr. Stark knows that the combined sovereign debt of Greece, Ireland, Portugal, and Spain totals around U.S.$2 trillion and that a large proportion of that debt is held by the European banking system. He also knows that a possible 30 percent average write down of that debt could inflict losses on the European financial system in an amount that is all too similar to that inflicted on the U.S. banking system by the sub-prime loan crisis in 2008.

An important reason why Mr. Stark's warning bears heeding is that markets are now seriously questioning whether the countries in the European periphery can really succeed in reducing their very large budget deficits in a manner that will allow them to avoid default. A particular market concern is that, stuck within a Euro straightjacket, these countries cannot boost their exports by currency devaluation as an offset to the very contractionary impact on their economies of severe budget reduction. The markets also fear that as these economies go into the deepest of economic recessions they will lose their political willingness to stay the course of austere budget policies.

As if to validate the market's concerns, there already has been the virtual collapse of the Greek and Irish economies that has been associated with major budget belt tightening. Over the past two years, the Greek and Irish economies have contracted by 8 percent and 12 percent, respectively, which has caused unemployment to surge to over 14 percent in both of these countries. At the same time, as a result of dismal economic performance, governments have already fallen in Ireland and Portugal, while the Spanish prime minister has declared that he will not be seeking re-election in 2012.

Against this backdrop, and despite very large IMF-EU bailout packages for Greece, Ireland, and Portugal, markets are now demanding record interest rates for lending to the governments in the European periphery. Indeed, in the case of Greece, markets are now demanding close to 25 percent a year on two-year Greek government bonds. Such high rates imply that markets are now assigning more than a 60 percent probability to the likelihood that the Greek government will default over the next few years. This makes it highly improbable that Greece can return to the market in 2012 for additional funds to cover its expected government borrowing needs that year.

A factor further heightening market concerns has been the political backlash against bailouts in Europe's North European core countries. The most recent indications of this backlash have been Chancellor Merkel's electoral setbacks in German state elections and the rise of highly nationalistic political parties in Finland and the Netherlands at the polls.

In the year ahead, it is all too likely that economic performance in the European periphery will continue to disappoint as a result of the implementation of IMF-imposed draconian budget retrenchment within a Euro straightjacket. It is also all too likely that the political resistance to further bailouts of the periphery will intensify in Europe's northern member countries as the peripheral countries seek further assistance after having already received unusually large financial support from the north.

In assessing the speed at which the extraordinary fiscal and monetary policy support should be withdrawn from the U.S. economy, U.S. policymakers should be keeping a close eye on European economic and political developments. Since those developments have the all too real potential to trigger a European banking crisis and thereby to roil global financial markets in a manner that could very well set back the U.S. economic recovery.

Desmond Lachman is a resident fellow at AEI.

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