The Year of the Sovereign Debt Crisis

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The seriousness of any intensification of the eurozone debt crisis for the global economic recovery should not be underestimated. This crisis has the potential to deliver a major blow to the European banking system, which is the main holder of the European periphery's US$2 trillion in sovereign debt obligations.

Over the next twelve to eighteen months, there is every prospect that Greece and Ireland will choose to restructure their sovereign debt. They will do so as their economies sink further into the deepest of recessions under the weight of the draconian fiscal adjustment being imposed on these countries by the International Monetary Fund and the European Union within the straightjacket of their euro membership.

A Greek or Irish sovereign debt restructuring would constitute the largest such restructuring in history. It would also more than likely result in an escalation in contagion to Portugal and Spain, since both of these countries have extraordinarily large external financing needs in 2011.

A banking crisis in Europe, coupled with a renewed European economic downturn, will have serious implications for the global economic recovery. In particular, it would heighten the risks of a petering-out in the U.S. economic recovery, since it would come at precisely a time when U.S. unemployment remains unusually high, the foreclosure crisis continues unabated, and international oil prices are again at high levels.

A deepening in the European crisis must be expected to result in a further weakening in the euro, which would put U.S. exporters at a competitive disadvantage, since it would heighten existential questions about the euro. It must also be expected to result in an increased degree of global risk aversion given the great degree of interconnectedness of the world's financial system.

Desmond Lachman is a resident fellow at AEI.

Photo Credit: iStockphoto/University of Texas

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