By John W. Schoen Senior producer
msnbc.com
updated 7/12/2011 2:29:34 PM ET 2011-07-12T18:29:34

The debt crisis in Europe may seem like an ocean away from the political donnybrook playing out over the U.S. budget. Europe’s woes may soon hit a lot closer to home, though, as austerity measures there throw more cold water on the global economy.

Foreign trade is one of the last bright spots left for the U.S. economy. As struggling euro zone countries slash their budgets and rein in borrowing, those spending cuts will hit the bottom lines of American companies.

The latest read on U.S. exports came Tuesday from the Commerce Department, which reported that the surge in oil prices sent the trade deficit to its highest levels since 2008. But the export side of the ledger is still holding up relatively well, according to Paul Dales, senior U.S. economist at Capital Economics.

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“Net trade made a decent positive contribution to real GDP growth in the second quarter,” he said. “Without that, the economy may have ground to a complete halt.”

But demand for U.S. goods in Europe is already slowing as the weaker economies in the region slash spending to try to cope with a worsening debt crisis. U.S. exports to the European Union were $27.5 billion in May — nearly 20 percent of total exports. That’s down from a record $30.3 billion in March.

Europe’s debt crisis could hurt the U.S. economy in several ways. As debt-swamped governments tighten spending, some of those cuts will hurt American companies exporting products and services to the euro zone.

Italy may become the new 'I' in PIGS

As worries over the Greek debt crisis have spread, investors have pulled money out of other weak European economies, putting downward pressure on the euro and thereby strengthening the dollar. A stronger dollar helps keep interest rates low in the U.S. but also makes it harder for American companies to keep their prices competitive when they sell into European markets.

Until this week, the hope was that steep spending cuts would be limited to Greece, which has been stumbling from one budget crisis to the next for over a year. But the debt contagion appears to be spreading.

This week, investors began fleeing Italian bonds over worries of a possible downgrade of Italian government debt. In response, the government in Rome scrambled to assemble a $68 billion austerity package to balance the budget by 2014. But investors remain skeptical about whether those cuts can right Europe's third-largest economy.

Balancing the Italian budget will be a tall order. The government is currently carrying a debt load of roughly 125 of gross domestic product, which has grown just 0.1 percent in a last two quarters. In comparison, the U.S. federal debt will reach roughly 70 percent of GDP by year-end, according to a recent report from the Congressional Budget Office.

Much as Greece has seen its economy contract in the face of heavy spending cuts, Italy faces the prospect of a nasty recession as it moves to balance its budget.

Major Market Indices

That economic slowdown will likely spread to other European countries if the debt crisis continues to widen. Capital Economics estimates that cutting Italy’s debt to the euro zone average would shave almost 10 percent off euro zone GDP.

As investors flee Italian bonds, that will raise the cost of financing Italy’s debt and cut the value of its bonds held by Italian banks. Their stocks have been hammered this week on fears that the banks may not have enough capital to cover their bonds losses.

The wider worry is that European authorities, already divided over whether to continue bailing out Greece, may balk at taking on even larger bailouts if Ireland, Spain or Portugal come calling for help. Critics of the European Central Bank say that if the debt crisis spreads the ECB may soon have too many fires to put out.

“They’re not even fiddling while Rome burns; they don’t even have a fiddle at this point,” said Citigroup chief economist Willem Buiter. “The financial facilities at their disposal are wholly inadequate to deal with Spain or Italy separately, let alone together. So we need an immediate increase in the size of the resources available.”

The spread of Europe’s debt crisis to Italy has also brought the Washington wrangling over the U.S. debt ceiling into sharper focus. For now investors apparently believe a default by the Treasury is all but impossible. But the crisis in Italy is a reminder that investors betting that a default will happen — so called “bond vigilantes” — can strike without warning.

“(Italy) is the first G7 country where the bond vigilantes in this cycle have hit,” said investment manager Subodh Kumar, an independent financial market analyst. “So it’s not a stretch to say, ‘Why shouldn’t that happen to Washington if there’s no action in terms of the budget deficit?'”

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