Greece Is a Major Threat to the U.S. Economic Recovery

One should not underestimate the seriousness of the Greek economic crisis for the US economic outlook for the following three reasons:

  • There is every prospect that within the next twelve to eighteen months Greece will default on its US$420 billion in sovereign debt. This would constitute the largest sovereign debt default in history and would dwarf those in Russia in 1998 and in Argentina in 2001.

  • A Greek default would almost certainly result in contagion to Spain, Portugal, and Ireland. This would raise the potential for a shock to the European banking system on a scale of that experienced in the aftermath of the September 2008 Lehman failure.

  • A major European economic recession and banking crisis would considerably heighten the probability of a double-dip US economic recession in 2011.

The credit markets are presently assigning a 75 percent probability to a Greek sovereign debt default before 2015. Any such default would almost certainly result in intense contagion to Spain, Portugal, and Ireland since markets would no longer have the assurance that no Euro-zone country will be allowed to fail. Like Greece, all of these countries have highly compromised public finances and severely eroded international competitiveness positions. And like Greece, their Euro-zone membership, precludes their using exchange rate devaluation as a means to address these two problems.

The deep economic and solvency problems in Greece, Spain, Portugal, and Ireland constitute a serious risk to the European banking system. The total sovereign debt of these countries exceeds US$2 trillion and the major part of this debt is held by the European banks. An eventual write down of these countries' debt by an average 30 cents on the dollar would constitute as large a shock to the European banking system as that which it experienced in 2008.

Any further deepening in the Euro-zone crisis would heighten the risks of a double dip US recession in 2011 since the US economy would be negatively impacted by the European crisis through the following three channels:
  • The dollar would continue to appreciate against the Euro as markets would become increasingly concerned about Europe's economic growth prospects and about the possibility of an eventual break-up of the Euro-zone. This would put US exporters at a significant competitive disadvantage with respect to Europe. Over the past year, the Euro has already depreciated from US$1.60 to its present level of US$1.25.

  • A recession in Europe would further diminish demand for US exports by reducing the buying power of an important US trade partner.

  • A further deepening in the European crisis is very likely to result in increased risk aversion in global financial markets and renewed declines in global equity markets. This would appreciably increase borrowing costs and reduce credit availability for both US households and corporations exactly at the time that the positive contribution to GDP growth from the fiscal stimulus package is fading.

Desmond Lachman is a resident fellow at AEI.

Photo Credit: Flickr User pguilliatt/Creative Commons

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