After many years of lectures from Europeans about the superiority of their economic and social model, it is tempting for Americans to derive some satisfaction from the Continent's present sovereign-debt crisis. However, such a reaction would be misplaced, given that Europe's debt crisis has the potential to derail the fragile U.S. economic recovery. Even more disturbingly, Europe's crisis could revive political ghosts in a vital region of the world that today shares America's commitment to freedom and democracy.
The underlying causes of Europe's debt crisis are the large budget deficits that developed over the past decade in Greece, Ireland, Portugal, and Spain. Whereas euro-zone rules prohibit budget deficits in excess of 3% percent of GDP, by 2009 Greece's budget deficit had exceeded 15% of GDP, Ireland's and Spain's had both surpassed 11%, and Portugal's was more than 9%. These large deficits contributed to wage and price inflation in these countries that has rendered them uncompetitive in international markets.
Locked into the discipline of the euro, Portugal, Ireland, Greece and Spain cannot resort to inflating their way out of debt. Nor can they attempt to devalue their currencies so as to make their exports more attractive abroad and thus offset the impact of the fiscal retrenchment being imposed on them by the International Monetary Fund.
Attempting to tighten their budgets without weakening their currencies is, necessarily, a recipe for steep recession in these countries. Sadly, Greece and Ireland are already finding this out. Over the past two years, GDP has contracted in Greece and Ireland by 5% and 12%, respectively, and their unemployment rates have both climbed beyond 14%.
The seemingly intractable economic problems in Greece, Ireland, Portugal, and Spain constitute a serious risk to the global banking system. Although these economies constitute a relatively small part of the overall European economy, their cumulative sovereign debts exceed $2 trillion or just over 13% of the euro area's GDP. The major part of this debt is held by German, French, and British banks, whose fortunes in turn are enmeshed with those of U.S banks. Eventually, these countries' debts will likely be written down by at least 20 cents on the dollar, which will hit the European banking system about as hard as did the 2008 Lehman Brothers meltdown.
That's just the status quo. If the European debt crisis continues to worsen, the U.S. dollar will likely strengthen significantly against the euro, dragging on America's short-term international competitiveness. It would also likely usher in the return of global risk aversion, heightening the risks of a double-dip recession in the U.S., where unemployment is already high and the housing market continues to fall.
The euro crisis's economic consequences are deeply troubling, but its political ramifications are even more disturbing. Over the last 60 years, European countries have pursued ever-closer economic and political integration in an attempt to avoid repeating their mistakes between World Wars I and II. This bold experiment in unity has delivered the Continent's longest period of peace and rising prosperity, but all that could end if Europe were once again to break off into first- and second-class nations.
As if to underline these political risks, the past year has been punctuated by labor unrest and public anger in the streets of Athens, Dublin, Lisbon and Madrid. The tumult has considerably weakened the ruling parties in all these countries, and serves as a grim reminder of how badly Europe's political systems have historically held up to economic stress.
Americans and Europeans often disagree on the finer points of trade, fiscal policy, and which battles on the world stage are worth fighting. But today Europe stands as America's premier partner in democracy and free markets--both in pursuing these ideals at home and championing them abroad. Today's sovereign-debt crisis threatens Europe's economic and political fabric, and indeed its very union. That's as serious a problem for the U.S. as it is for Europe, and one that people on both sides of the Atlantic should be eager to solve.
Desmond Lachman is a resident fellow at AEI.