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There can be little doubt that a deepening in Europe's sovereign debt crisis would pose a major risk to the still very fragile US economic recovery. It would do so not simply by clouding US export prospects through a strengthening of the US dollar and a weakening of European markets. Rather, it would do so mainly by destabilizing global financial markets and by intensifying the global credit crunch. A further pull back in bank lending is the last thing that the US economy needs right now.

In considering how a worsening in the Greek economic crisis might impact global financial markets, it is well to recall that in 2007 when a butterfly flapped its wings in as insignificant an economy as Iceland, shudders were felt throughout the financial world. Similar ripples were felt late last year when Dubai World appeared poised to default. If such small countries had an impact on global financial markets, how much more so should one expect a worsening in the Greek situation to do the same?

Greece's sovereign debt is presently around US$400 billion, or around four times that of Russia and Argentina when they defaulted in 1998 and 2001, respectively. This alone should give cause for worrying about the negative impact on global economic markets that would result from an increased market perception that Greece will not be able to honor its sovereign debt obligations. What makes the Greek situation all the more worrisome is that any failure in Greece is bound to set off dominoes falling in countries like Spain, Portugal, and Ireland. These countries too all suffer from the weakest of economic fundamentals. It is difficult to see how such an eventuality would not have a major negative impact on the European banking system as well as on the global financial system.

Greece is likely to get a temporary reprieve from its crisis by the bailout now being actively discussed by European finance ministers. However, the very strong public opposition voiced in Germany to any Greek bailout would suggest that it will be difficult for European governments to orchestrate repeated bailouts of that country. This should give additional pause to the Federal Reserve in its contemplation of an early exit from its policy of extraordinary monetary policy easing.

Desmond Lachman is a resident fellow at AEI.

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