May 16, 2012 at 1:06 PM ET
As Greece teeters on the edge of financial collapse, European officials have a new task before them: preventing the financial turmoil from spreading across the continent, across the Atlantic and around the rest of the world.
The fear is that Greece’s financial turmoil could spread beyond its borders despite European efforts to create a “financial firewall” to contain it.
“The spillover effects, the chain of consequences are very difficult to assess,” said International Monetary Fund President Christine Lagarde on Wednesday. “We can certainly assume that it would be quite messy.”
Lagarde, whose agency has been among those providing financial support for Greece, said the IMF has begun making “technical” preparations for Greece’s possible departure from Europe’s common currency, the euro.
Greece’s exit from the eurozone seems more likely every day. A two-year standoff deepened this week between Greek voters, 1 in 5 of whom are unemployed, and European officials, led by German Chancellor Angel Merkel, who are insisting on continued “austerity” by the Greek government in exchange for a financial lifeline.
After deep budget cuts sent the Greek economy into a painful recession, voters ousted the former government that agreed to measures that would inflict even more pain on Greece’s banks, businesses and households.
Merkel and Lagarde remain steadfast in their insistence that continued financial aid depends on whether Athens adheres to tight-fisted spending policies.
"Nobody is going to give the Greeks a penny unless they put a government in place which implements austerity,” said David Roche, president of Independent Strategy, a London-based investment research firm.
Depositors have already begun pulling their euros out of Greek banks as the odds rise that Athens may soon exit the common currency.
Without continued financial aid, the Greek government is expected to run out of cash in a few weeks. That would almost certainly bring another round of bond defaults, increasing pressure to abandon the euro.
Beyond defaults on debt issued by the government, Greece’s suspension of the euro as its official currency would likely invalidate much of the more than half trillion dollars’ worth of private borrowing by households, companies and other levels of government. That would drive its economy even deeper into recession.
Without a backstop, Greece’s banking system would also face a sharp contraction, if not collapse, as the value of its assets implode. Analysts estimate that the value of any new currency -- the drachma, for example -- introduced to replace the euro would force markdowns of as much as 50 percent or more.
The immediate impact on U.S. banks would likely be limited. After sharply reducing exposure to Greece for the past two years, American banks hold roughly $6 billion worth of Greek government debt.
But the effect on the European banking system could be severe if investors and depositors grow increasingly fearful that other debt-heavy countries, such as Spain, Italy, Ireland or Portugal, might also eventually leave the euro zone.
“Capital flight from those countries would have to be ring-fenced by unlimited amounts of government bond buying by the European Central Bank and also with guarantees for depositors so they wouldn’t take their money out of places like Portugal, Ireland, Italy and Spain,” said Roche. “Are we ready? No.”
The financial markets are already anticipating further deterioration; investors are bailing out of stocks across Europe, with bank stocks especially hard hit. They’re also dumping Spanish and Italian government bonds, driving yields to the kind of unsustainable levels that initially sparked the Greek crisis two years ago.
Since then, European officials have been cobbling together a “financial firewall” – a series of measures to backstop failing banks and prevent another full-blown crisis. The latest move late last year by European central bankers to lend banks roughly $1 trillion in cash has apparently provided only a temporary reprieve. Banks hoarding cash to weather the coming storm have tightened credit, further slowing local economies.
Other agencies, including the IMF and a recently created “stability” fund, are also available to help put out any financial fires. But analysts – and some American officials - have long expressed concerns that Europe’s bailout fund isn’t nearly big enough to handle a banking crisis that spreads beyond Greece.
"Greece is peanuts as far as the United States is concerned," said Uri Dadush, former economic policy chief at the World Bank. "But if Greece leads to the contagion of Spain and Italy, the euro could implode. This is big business for the U.S. We're talking trillions of dollars in direct and indirect exposure to the European banking sector."
Ongoing demands for austerity in exchange for financial aid have brought Europe’s economy to a dead stop. The latest data show gross domestic product flatlined in the first quarter, largely because the ongoing turmoil has sapped business and consumer confidence and spending.
That could spell more trouble for America's businesses and consumers.
With U.S. government spending contracting and consumer spending weakened by slow wage growth, manufacturing exports have provided one of the few bright spots for the U.S. economy. In the last five months, U.S. manufacturers have added 167,000 jobs to their payrolls.
Until recently, Europe was a ready market for goods made by those workers. More than half of U.S. foreign investment and a fifth of all American exports end up in the European Union.
But unemployment in Europe, currently at 10.9 percent, is rising. In Spain and Greece, half of the work force under 25 is out of a job.
American companies are already feeling the impact; U.S. car makers Ford and General Motors recently reported that first quarter profits were hurt by a slowdown in car sales to European buyers.
A continued slide in the value of the euro would make matters worse for U.S. companies by making their products more expensive in those markets.
"Right now, the best case scenario in Europe is a recession," said Chad Moutray, economist at the Washington-based National Association of Manufacturers. "Any of the worst case scenarios threaten our growth strategy."