The euro crisis and the US taxpayer

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German Chancellor Angela Merkel and French President Nicolas Sarkozy arrive for talks on the Greek debt crisis at the Chancellery on June 17, 2011, in Berlin.

Article Highlights

  • Greece's economic freefall makes substantial write-down in its US $450 billion sovereign debt highly probable

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  • IMF lending puts US taxpayers at risk for almost $20 billion

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  • If Italy and Spain go to IMF for major loans, US taxpayer exposure could be $220 billion

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Read the full testimony as a PDF: The euro crisis and the US taxpayer

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Thank you Chairman McHenry, Ranking Member Quigley, and members of the Subcommittee for affording me the great honor of testifying before you today. My name is Desmond Lachman, and I am a Resident Fellow at the American Enterprise Institute. I am here in my personal capacity and I am not here to represent the AEI's view.

In the testimony that follows I set out the reasons why I think that there will be a further significant intensification of the Euro-zone debt crisis in the months immediately ahead that could result in the Euro's unraveling within the next twelve months. I also draw out the serious risks that the Euro-zone crisis poses to the US economic recovery, and I consider the potential cost to the US taxpayer of the various measures being undertaken by the IMF and the Federal Reserve to defuse the crisis.

The Euro Crisis is intensifying

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

    Among the signs of intensification are the following:
    • The Greek economy now appears to be in freefall as indicated by a 12 percent contraction in  real GDP over the past two years and an increase in its unemployment rate to 18 ½ percent. Greek banks are now rapidly losing deposits. This makes a substantial write-down (of perhaps as much as 75 cents on the dollar) in 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 and would almost certainly accentuate the contagion that is already in evidence in the European periphery.
    • Contagion from the Greek debt crisis has been 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.
    • There are already signs of substantial deleveraging and credit tightening by the European banks. This tightening is occurring at the very time that European economies are weakening and at a time that major fiscal consolidation efforts are underway.
    • 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 European Central Bank (ECB) is correctly warning that a 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.
  3. Since July 2011, the Italian and Spanish bond markets have been under substantial market pressure. This has necessitated more than US $130 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 is currently around US$4 trillion.
  4. While European policymakers are partly 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 ratio 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. 

  5. 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 US $300 billion, while some private estimates consider that the banks are undercapitalized by more than US $400 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.  Private market analysts are fearful that the European banks might reduce lending by as much as US$3 trillion over the next eighteen months. 

  6. European policymakers are hoping that the countries in the European periphery can correct their large internal and external imbalances by several years of strict fiscal austerity within the framework of a European-wide fiscal treaty to be negotiated by March 2012. It remains to be seen whether such an approach can work within the straightjacket of Euro membership that precludes currency devaluation to boost exports as an offset to the negative economic impact of budget tightening. This would especially appear to be the case at a time that the European economy already shows signs of weakening and at a time that Europe is about to experience a major credit crunch. Indeed, there is the very real risk that continuing to apply substantial fiscal tightening will lead to a very deep economic recession. A deep recession would make it very difficult for countries to reduce their budget deficits and would undermine their political willingness to remain within the Euro.

 

Continue reading the full testimony here.

Desmond Lachman is a resident fellow at AEI

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