Implications of the Euro Crisis for the United States

Moritz Hager/World Economic Forum

George A. Papandreou, Prime Minister of Greece, presents during the session 'Europe: Back to the Drawing Board?' at the Annual Meeting 2011 of the World Economic Forum in Davos, Switzerland, Jan. 27, 2011.

Read the full testimony as an Adobe Acrobat PDF

The Euro Crisis is Intensifying

1. Over the past few months, there has been a marked intensification of the Eurozone debt crisis that could have major implications for the United States economy in 2012. Among the signs of intensification are the following:

a. The Greek economy now appears to be in virtual freefall as indicated by a 12 percent contraction in real GDP over the past two years and an increase in the unemployment rate to over 15 percent. This makes a substantial write down of Greece's US$450 billion sovereign debt highly probable within the next few months. Such a default would constitute the largest sovereign debt default on record.

b. Contagion from the Greek debt crisis is affecting not simply the smaller economies of Ireland and Portugal, which too have solvency problems. It is now also impacting Italy and Spain, Europe's third and fourth largest economies, respectively. This poses a real threat to the Euro's survival in its present form.

c. The Euro-zone debt crisis is having a material impact on the European banking system. This is being reflected in an approximate halving in European bank share prices and an increase in European banks' funding costs. French banks in particular are having trouble funding themselves in the wholesale bank market.

d. There are very clear indications of an appreciable slowing in German and French economic growth. It is all too likely that the overall European economy could soon be tipped into a meaningful economic recession should there be a worsening in Europe's banking crisis. A worsening in the growth prospects of Europe's core countries reduces the chances that the countries in the European periphery can grow themselves out of their present debt crisis.

2. The IMF now acknowledges that Greece's economic and budget performance has been very much worse than anticipated and that the Greek economy is basically insolvent. The IMF estimates that Greece's public debt to GDP ratio will rise to at least 180 percent or to a level that is clearly unsustainable. The IMF is proposing that the European banks accept a 50-60 cent on the dollar write-down on their Greek sovereign debt holding. This would have a material impact on the European banks' capital reserve positions.

3. The European Central Bank (ECB) is correctly warning that a hard Greek default would have a devastating effect on the Greek banking system, which has very large holdings of Greek sovereign debt. This could necessitate the imposition of capital controls or the nationalization of the Greek banking system. The ECB is also rightly fearful that a Greek default will soon trigger similar debt defaults in Portugal and Ireland since depositors in those countries might take fright following a Greek default. This has to be a matter of major concern since the combined sovereign debt of Greece, Portugal, and Ireland is around US$1 trillion

4. Since July 2011, the Italian and Spanish bond markets have been under substantial market pressure. This has necessitated more than EUR 75 billion in ECB purchases of these countries' bonds in the secondary market. An intensification of contagion to Italy and Spain would pose an existential threat to the Euro in its present form given that the combined public debt of these two countries currently around US$4 trillion.

5. While to a large degree European policymakers are right in portraying Italy and Spain as innocent bystanders to the Greek debt crisis, Italy and Spain both have pronounced economic vulnerabilities. Italy's public debt to GDP is presently at an uncomfortably high 120 percent, while it suffers from both very sclerotic economic growth and a dysfunctional political system. For its part, Spain is presently saddled with a net external debt of around 100 percent of GDP, it still has a sizeable external current account deficit, and it is still in the process of adjusting to the bursting of a housing market bubble that was a multiple the size of that in the United States.

6. Sovereign debt defaults in the European periphery would have a major impact on the balance sheet position of the European banking system. The IMF estimates that the European banks are presently undercapitalized by around EUR200 billion, while some private estimates consider that the banks are undercapitalized by more than EUR300 billion. It is of concern to the European economic outlook that there are already signs of the European banks selling assets and constraining their lending to improve their capital ratios.

Desmond Lachman is a resident fellow at AEI

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Desmond
Lachman
  • Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund's (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.
  • Phone: 202-862-5844
    Email: dlachman@aei.org
  • Assistant Info

    Name: Emma Bennett
    Phone: 202.862.5862
    Email: emma.bennett@aei.org

What's new on AEI

image The Census Bureau and Obamacare: Dumb decision? Yes. Conspiracy? No.
image A 'three-state solution' for Middle East peace
image Give the CBO long-range tools
image The coming collapse of India's communists
AEI on Facebook
Events Calendar
  • 21
    MON
  • 22
    TUE
  • 23
    WED
  • 24
    THU
  • 25
    FRI
Wednesday, April 23, 2014 | 12:00 p.m. – 1:30 p.m.
Graduation day: How dads’ involvement impacts higher education success

Join a diverse group of panelists — including sociologists, education experts, and students — for a discussion of how public policy and culture can help families lay a firmer foundation for their children’s educational success, and of how the effects of paternal involvement vary by socioeconomic background.

Thursday, April 24, 2014 | 12:00 p.m. – 1:30 p.m.
Getting it right: A better strategy to defeat al Qaeda

This event will coincide with the release of a new report by AEI’s Mary Habeck, which analyzes why current national security policy is failing to stop the advancement of al Qaeda and its affiliates and what the US can do to develop a successful strategy to defeat this enemy.

Friday, April 25, 2014 | 9:15 a.m. – 1:15 p.m.
Obamacare’s rocky start and uncertain future

During this event, experts with many different views on the ACA will offer their predictions for the future.   

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled today.
No events scheduled this day.