By John W. Schoen Senior producer
msnbc.com
updated 5/21/2010 2:28:12 PM ET 2010-05-21T18:28:12

Europe's gathering storm has shaken investor confidence in the still-fragile U.S. economic recovery. What's more, it has brought an end to a 14-month surge in stocks fueled by the belief that the worst of the Great Recession was over.

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The recent drop in stock prices — about 10 percent from their peak — may represent a brief “correction” from a market that had gotten ahead of itself.

But the uncertainty over Europe’s financial turmoil, and the lack of a convincing solution, will likely weigh on the market for some time, experts say, despite occasional up days.

"I think you're going to have plenty of dips to buy on this summer," said investment strategist Ed Yardeni. "Because you don't know what will come out of Europe and what finance minister is going to make a statement — or what policy change will be made by this union of countries that can't seem to get their act together."

Despite recent pledges of a $1 trillion backstop, the global financial markets remain worried about a possible default by Greece and rising strains on the weakest Euro zone economies.

“Even $1 trillion is not calming the markets,” economist Nouriel Roubini told CNBC. “The trouble  is that looks like a large amount of money. But the hard slog of fiscal austerity and restoring competitiveness and structural reform is going to be very hard. And it is going to take years of sacrifices.”

Roubini said with parts of the global economy facing a "double-dip" recession, the stock market could sell off another 20 percent from current levels.

European officials coping with the crisis facing an increasingly thorny dilemma. Forcing spending cuts and tax increases on weaker countries with high debt loads and large deficits will further weaken those economies. Continued borrowing, in the other hand, will force interest rates higher. Flooding the system with money to “monetize” those debt risks fuels higher inflation.  

“So you’re damned if you do and damned if you don’t,” said Roubini. “That’s the challenge that all governments are facing right now.”

Recent efforts to shore up the sagging euro have exposed deep political tensions, further undermining confidence in the currency.

"There are multiple scenarios and I think that's what's driving the markets nuts," Paul McCulley, PIMCO managing director.

Video: Pimco on markets

Those scenarios could spell trouble for the nascent economic recovery in the U.S. A falling euro may be good news for an America tourist in Paris, but it's bad news for U.S. businesses, bankers and policymakers.

The decline in the euro hurts American companies in several ways. First, it makes it harder to export products to the euro zone, where U.S.-made goods are now more expensive in local currency. For American companies with substantial European operations, the falling euro shrinks those profits when they’re converted back into dollars.

Europe’s financial rescue plan also comes with severe belt-tightening by the governments of Greece, Spain and Portugal. Those cuts will weigh on an already weak European economy, further cutting demand for U.S. products and services.

The debt turmoil in euro has also spark fears that the crisis could hurt U.S. banks holding public or private European debts. That in turn could prompt lenders to pull back even further on extending credit.

That poses a "potentially serious" risk to the U.S. economic recovery, according to Federal Reserve Governor Daniel Tarullo, who told a Congressional panel Thursday that, unless contained, Europe's debt crisis could freeze financial markets and bring on another market meltdown that followed the Panic of 2008.

"If sovereign problems in peripheral Europe were to spill over to cause difficulties more broadly throughout Europe, U.S. banks would face larger losses on their considerable overall credit exposures," Tarullo told the panel. "In addition to imposing direct losses on U.S. institutions, a heightening of financial stresses in Europe could be transmitted to financial markets globally."

European officials and the International Monetary Fund have responded to the euro crisis with a massive bailout fund similar to the $700 billion U.S. bank bailout of 2009. But there is growing concern that the underlying problem in Europe is political, not financial. Though stitched together with a common currency, the euro zone is confronting a deepening political divide between the wealthier countries to the north and the weaker economies in the south

"Monetary union without political union and physical union was always the Achilles’ heel of the European experiment," said McCulley. "Essentially, the north is having to bail out the south.

"It’s very similar to making a loan to your unemployed brother-in-law," he said. "You really don't want to do it, but if you don't do it, he's going to move into your recreation room. So you hold your nose and do it, but it's not a long-term solution because he’s still unemployed."  

All of this is particularly worrisome as the U.S. economy has shown signs recently that it's struggling again. Thanks largely to a massive surge in government stimulus spending, the U.S. economy bounced back sharply in late 2009 and early this year. But the impact of that jump-start may be fading.

Consumer spending eased in April, led by a drop in car sales. The housing market is bowing under a record pace of foreclosures and a drop-off in demand after the end of a homebuyer tax credit in April. And the job outlook remains murky. Despite a pickup in job creation earlier this year, the Labor Department reported Friday that mass layoffs by U.S. employers rose in April, led by manufacturers who cut workers even as the economy began to recover.

Much of the snapback in the economy has come from businesses restocking their shelves after deep cuts in inventory during the recession. Despite recent signs of strength, “final demand has not yet shown a vigorous rebound,” said Goldman Sachs chief economist Jan Hatzuis, who expects the economy to slow from real GDP growth of a little over 3 percent in the first half of the year to 1.5 percent in the second half.

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